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The Basic Stochastic Indicator

Futures traders have discovered through trial and error (mostly through error) that effective timing indicators can be applied in many ways and in a variety of combinations with other indicators. Dr. George Lane advanced numerous applications for his stochastic indicator; I have, through persistence, considerable research, and the "school of hard knocks" amplified on George Lane's original research. In fact, George has adapted at least one of my uses of stochastics, the stochastic pop indicator, to his own use.

Simply stated, the SI is a price oscillator which compares today's price behavior with the behavior of prices x number of periods ago. A 14-day SI, for example, compares a derivative of today's price with price 14 trading days ago. The raw stochastic number is converted to a percentВэage reading, smoothed, and then compared to a moving average of itself. Hence, the SI consists of two numbers expressed as percent at each price bar. Since both lines are smoothed, and since one line, percent D is a derivative of percent K (usually a 3-period moving average of the first-line percent JO the visual effect is one which easily shows highs and lows in the SI correlated closely with highs and lows in price.

There are two forms of the SI, fast and slow. The fast SI consists of two lines which often gyrate wildly from low to high and back again, and the slow SI is a smoothed version of fast and moves more gradually from low to high and back again. There is a strong correlation between tops and bottoms in price and SI tops and bottoms. The SI is, therefore, a powerful indicator which may be used by short-term, position, and day traders alike.

The important issue regarding the SI, whether fast or slow and whether 9-period or 25-period, is its method of application. As we will see later on there are numerous ways in which SI may be used. It is the purpose of this chapter to provide you with what I feel are some of the most powerful methods for day traders. I am confident that those who understand and consistently apply the principles we are about to teach will appreciate both the simplicity and power of our techniques.

Before introducing the basic approaches to SI timing I'd like to stress the following important aspects of stochastics:

1. Many traders consider an SI of 75 percent or higher as an indication that a top is imminent, and a stochastic of 25 percent or lower is often considered an imminent sign of a bottom.

2. The fact that the SI reaches an overbought condition (i.e., 75 percent or higher) or an oversold condition (25 percent or lower) does not necesВэsarily indicate that action should be taken immediately. This is the sinВэgle most severe drawback of traditional stochastic implementation.

3. The SI is used by many traders as a stand-alone system. Although there is nothing wrong with this approach, I have found that with only a few exceptions the additiojijof_tijTun^ improve overall results, regardless of which SI technique you are using.