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STOCHASTIC OSCILLATOR

Now that we have done the calculations and arrived at the values necessary to plot the stochastic, we should spend some time trying to see what this study can tell us about the character of the market.

If we look at figure 2 we see the plot of the stochastic on the lower half of the chart and price represented on the upper half. Notice that as the "%D slow" (solid line) and "K slow" (dash line) rise from their origin that the "K" line will cross the "%D" line, on the right, then the two usually change direction until the next cross of the "K" and "%D". The crossover forms the basis for interpretation of the stochastic.

Divergence of the "%D" line and the stock or commodity's price is a signal of prime importance.

Divergence can be defined with an example: when the price of a commodity or stock make a high, react, then make a higher high while the line representing the "%D" makes a high then makes a lower high, this is called a bearish divergence. The same holds true for lower price movement after a reaction high, while the "%D" fails to make a lower low, thus we have a bullish divergence. The crossover is then the signal to act based on a divergence signal. Divergence is then one of the tipoffs that there could be a change in the trend of that market.

Other indications that we can use are the warning and failure. A warning occurs when the direction of the "K" line changes sharply but does not cross "%D" line that day. This would indicate that a crossover of the "K" and "%D" is probably within two days. A failure occurs when the "K" line after crossing through the "%D" pulls back a few percent but does not cross back thru the "%D" before moving higher.

This signal indicates strength and will usually be followed by higher highs for both price and "%D". I feel that the place to start this analysis is with either a weekly or monthly chart. In this case we will use the weekly chart in figure 2. The bar chart says that we are definitely in a down trend and will remain that way until the price manages to penetrate the trend line A. The stochastic chart seems to confirm the analysis since the trend line "C" shows no divergence to the bar chart.

There is an example of divergence on this chart when we examine the lows. As the bar chart makes lower lows the stochastic is making higher lows. This signals that we could be near the price low for this move down. The confirming stochastic signal would be divergence with the bar chart highs and a move above the trend line "C".

The weekly or monthly chart should be used as an indicator of which signals to accept and which to ignore on the daily chart. In this case to follow the rules one should ignore the daily sell signals since the weekly has turned long. A good technician would probably also check the monthly stochastic to see which side of the market it indicated. In this case the monthly confirms that we are still in a down trend so the weekly chart is alerting us to the possibility of a market turn around in the near future.

Notice also that before the "K" line crosses the "%D" the slope of the line changes and may turn down a period of time before the actual cross over. This is a warning that a crossover may be within one or two days and you should take the necessary precautions. I use almost exclusively the slow or smoothed values for "%D" and "K" because they tend to be more confirmed signals, although they usually appear several days after a signal is generated using the regular method.

Let us now turn our attention to the daily price chart in figure 3. We see the bar chart confirming that the markets indeed are in a down trend, having not closed above the trend line since before the first of November. There is no divergence between the price and the "%D" plotted on the lower portion of the chart. It is important to note that trend lines can suggest points that may offer resistance or support to the "'%D".

During the month of January, only once were the trend lines on the stochastic chart penetrated and then within two days the indicator had again closed within the lines. It seems the signals that have the most validity tend to occur above 85% and below 15%. Generally if the "K"-line declines to a value of zero then a small rally of from two to five days will precede the attempt of the "K" to reach zero again. After this occurs there is a good chance that there could be at least a minor rally.

The opposite is true when "K" approaches one hundred. It will usually fall back, then retest the one hundred mark again, only to fall into a minor sell-off. Notice that after a signal below the 20% line the indicator rallied but failed below the 80% line. All was not lost because the next signal was higher than the previous low while prices were making a new low. This would indicate that prices should go higher at least until a signal is given above the 80% line.

As with any indicator, the system is by no means fool proof, so the process should be used along with and confirmed by other indicators that draw on a different type of signal. The stochastic seems to be a good coincidental indicator at best, so there must be some other method used that will give the entry and exit signals. Many times the move can be half over before a confirmed signal is given.

This is not too hard to understand since in the computation of the indices great weight is given to the values of the five day high and low. With study of the computations comes a better understanding of not only how each number is arrived at but also insight intra-day what

price action may be doing to the "%D" and "K" values. How much homework you do will have a great deal to do with your success in trading with the stochastic.

Figure 1

Figure 2

Figure 3