Analyzing the stochastic indicator,
once you have decided on the parameters, subjects the user to still another set
of alternatives. The stochastic is used by market analysts in several different
manners. First, some analysts use the stochastic as they would an
overbought/oversold indicator, similar to the way the Relative Strength Index
(RSI) is used. When the %K and %D readings are more than 75, this indicates the
instrument underlying the stochastic is overbought. Similarly, if the
stochastics are less than 24, the market is considered oversold.
Second, the stochastic is used like
other oscillators, such as the Net Change Oscillator (NCO). It is charted and
its peaks and troughs are compared to those of the underlying
instrument—particularly, divergence of the stochastic from the current price
trend is noted. If the stochastic moves in the opposite direction of the
current price trend, for instance, the price trend would be expected to reverse
in the direction of the stochastic in the near-term.
Third, the stochastic
may be analyzed like a moving average. Using a short-term and long-term period,
the stochastic is charted in tandem. A popular set of stochastics to plot
against the T-bond future is the 8- and 20-day %D. A similar study for S&P
futures is shown in Figure 2. One looks for the familiar moving average signals of changing or
confirming trend, such as short-term/long-term crossovers and short-term
leading and long-term patterns.
Stochastic software
Our telephone survey of
software manufacturers regarding their use of stochastics elicited the
information shown in Figure 3. Most companies were quite approachable when asked about their
programs' calculations and revealed whether their systems employed simple or
exponential moving averages, whether the user can choose the smoothing method
and what terminology they used to describe the stochastics.
Figure 3 is by no means
definitive and computer software companies are constantly developing new
programs or modifying existing ones. It is interesting to note the variations
in naming in just these few programs, and the confusion that arises when one
speaks of slow or fast, K or %K, %K or %D stochastics.
In conclusion, we have
noted that analysts who have spent time researching various periodicities and
smoothing techniques speak highly of the efficacy of the stochastic as a
trading tool. On the other hand, those who have only experimented in a limited
manner with the various parameters in the stochastic tend to come to
dissatisfactory conclusions on its usefulness. If you areВ interested in stochastics, examine the
features of the many inexpensive market software packages available. Look for
those packages which allow you the freedom to alter the periodicity of the
stochastic at any stage of the calculations, as well as offer you the freedom
to choose different smoothing methods.
Cynthia Keel is Director
of Technical Research at Money Market Services where Heidi Schmidt is a
Technical Research Analyst.
FIGURE 1
FIGURE
2
Stochastic & RSI
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