The Slow Stochastic

08/25/00 01:36:50 PM

by Sean Moore

The stochastic oscillator can be used to help predict range tops and bottoms. Many variations of the indicator can be used for different trading strategies. Look for divergence between the stochastics indicator and the price to produce a solid buy/sell signal.

Security: GE
Position: N/A

The stochastics indicator, first developed by George Lane, measures the relationship between the current closing price and the recent price range of a security. This relationship is typically plotted as an oscillator with two lines, the %K line and the %D line. The %K line represents the relationship between the current close and the price range for a given time period (typically 5-14 days). The %D line is a 3-day smoothed average of the %K line. This is typically known as the fast stochastic. The fast stochastic exhibits a lot of fluctuations and to smooth them out a variation known as the slow stochastic was created. The slow %K line is the 3-day moving average of the %D line. So the original %K line has been smoothed over twice to get the slow %K line.

The stochastic values give you an idea of where the closing price has fallen or risen with respect to the selected price range. The values are expressed in terms of a percentage with values above 80 indicating the top of the trading range and values below 20 indicating the bottom. Thus, the stochastics oscillator can be used to predict overbought and oversold conditions. In an overbought market, the buyers are uncomfortable buying and the sellers will begin to enter to take their profits driving the price downward. Naturally, the opposite is true for an oversold market, where the sellers become uncomfortable with the lower prices and buyers will enter anticipating the next upward swing.

Figure 1: Daily price chart for General Electric shown with a slow stochastic. The blue line drawn on the chart shows the divergenge that occured on June 2000 between the price data and the stochastic indicator.

Graphic provided by: WindowOnWallStreet.com.

There are three situations that can cause a buy or sell signal with the stochastic indicator. According to Lane, the most important is a divergence between the indicator and the price movement. Secondly, there is the position of the lines relative to the 80 and 20 lines (overbought/oversold areas). Thirdly, you can watch for crossovers between the %K line and the %D line. If the %K line crosses above the %D line, a buy is signaled. If the %K line crosses below the %D line, a sell is signaled.

The daily bar chart for General Electric [GE] in Figure 1 is plotted with the slow stochastic indicator. The %K line is shown in red, while the %D line is shown in green. It uses a 3-period simple moving average for the %K equation to help smooth some of the fluctuations. The %D line is a 3-period moving average of the %K line. Notice the divergence between the price chart and the stochastic indicator in June 2000. The price made a new low on June 26 but the stochastic did not. This type of divergence is key when using the stochastic indicator. When the fast line (%K) crossed over the slow line (%D) at point A, the divergence was confirmed and a buy signal was generated.

With several different options for generating and confirming buy/sell signals, the stochastic oscillator takes some practice to utilize effectively. Divergence between the stochastic indicator and the price is important. Once this divergence develops, look for a crossover between the %K and %D lines or stochastic levels above 80 or below 20. Like many oscillators, the stochastics oscillator performs best in a non-trending market (trading range).

Sean Moore

Traders.com Staff Writer.

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