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Do the multiple stochastic plots help identify buy and sell opportunities for stocks? Yes. First, you must determine the time frame you expect your trade to run. For example, if you are an intermediate-term trader, you might choose to follow the 50/5 stochastic line for crossovers of the 80 or 20 line. The trade is taken (open or closed) when this crossover occurs, but only if the next-longer stochastic line is also above 80 (for a sell signal) or below 20 (for a buy signal) . This signal works best with cyclical price movement but it should be confirmed by one or more of your other favorite indicators. This trading tool does not appear to be successful either with utility stocks or interest rate-sensitive stocks because of the recent strong underlying trend. It works equally well with low-priced (above, say, $2-3) and high-priced stocks.

Figure 5 shows two stochastic plots (150/5 and 50/5) for Alcoa (AA). The 50/5 stochastic plot crossed down through the 80 line several times and yet only the last crossover was successful. Not all trades will work. This technique would not have allowed the trader to ride with the entire move from mid-December to the end of May, because the stochastics indicator is an oscillator and not a trend-following method. A short-term trader can see several opportunities for trading options each time both stochastic plots turn upВ  or down.

Figure 6 shows similar data for Chevron (CHV). Three buy signals were given, in mid-December, early February and early March. Certainly, the signal in March would have been the most profitable. This is another reminder of the importance of using stop-loss orders to manage risk. If the trader was long a call purchased in March, then the first sell signal in mid-June should have caused the position to be closed. A short-term call buyer probably would have had a profitable trade in mid-December when both stochastics crossed the 20 line on the same day, but this signal was premature for the bottom.

Does this method work every time? No, because no indicator

does. Some trading opportunities will be lost, but it is better to make errors of omission rather than errors of commission.

An example of a low-priced stock is Bally (BLY), which is shown in Figure 7 with its two stochastic plots. Two sell signals were given, one in late January and one in late February. The late February signal would have been profitable. Both signals indicated that any long position must be closed. A buy signal was given shortly before the beginning of this chart. The crossover of the 20 line by the 50/5 stochastic in early June is not a valid buy signal because the 150/5 stochastic had not yet fallen below the 20 line. This only proves that this technique will miss some profitable opportunities.

If a large number of stocks are followed, it is impractical to chart each one daily to find out if any have the desired stochastic pattern. Let the computer do that job. Several technical analysis screening programs exist that will determine if a security meets any desired stochastic pattern. I initially used TechniFilter Plus 6.0 from RTR Software but now have updated to version 7.0, which calculates much faster. Usually, only a very small number of securities — less than 1% of all the stocks in the database per day — display a desired stochastic pattern. On some days, no stocks exhibit the desired pattern. Once the program identifies a security with a desirable pattern, I subject it to a detailed technical analysis before making any buy or sell recommendation.

The formula in TechniFilter Plus for the 50/5 stochastic is:

((C–LN50)/(HM50–LN50))A5

where LN50 is the lowest low of the past 50 days, HM50 is the highest high for the past 50 days and A5 is a five-day simple average of the 50-day stochastic.

Using TechniFilter and MetaStock together, I have been successful in finding tradable stocks by using a stochastic-based filtering system.

Two short-term stochastics can be used to identify the best times to sell uncovered OEX options. When both stochastics are above 80 or below 20, the OEX has reached short-term cyclical tops and bottoms during those times when the market is not in a strong up or down move. Such sideways movement occurs often, or at least it did during 1991 and 1992

Figure 8 shows two stochastic lines, 10/3 and 30/3. A +2 or –2 indicates that both stochastics are above 80 or below 20, respectively. A value of +1 or –1 shows that only the short stochastic is beyond its extreme value. While another indicator is needed to determine the exact day to place the trade, these spikes in the stochastic lines, if they endure more than one day, clearly correspond to turning points. To be successful with this trading method, good money management techniques are necessary to control the occasional losses.

In MetaStock, the formula to produce the chart in Figure 8 is:

if(stoch(10,3),

if(stoch(10,3),>,20,if(stoch(30,3),>,20,–2,–1),0))

I encourage the reader to experiment with values other than 10 or 30.

I have explored several ideas on the use of stochastic plots for timing trades from short to long term, for stocks and options. Despite the versatility of multiple-length stochastic plots, other indicators should be used to confirm the signals from the stochastics. Further research may improve on the findings presented here.

Stuart Meibuhr trades stocks and options for his own account. Recently moved to Scottsdale, AZ, he has lectured and taught on computerized investment topics for the past 10 years. He may now be reached at (602) 443-4926.

FIGURE 1: MONTHLY DOW JONES INDUSTRIAL AVERAGE, 14-BAR STOCHASTIC. Values below 20 indicate buying opportunities. The stochastics indicator stayed above 80 during most of the bullish phases.

FIGURE 2: MONTHLY CHART OEX (S&P 100 INDEX) 14-BAR STOCHASTIC. The 14-period

stochastic turned up from 20 at opportunistic times.

FIGURE 3: DAILY CHART OEX FROM MAY 1987 THROUGH JUNE 1988 AND THE 294-BAR STOCHASTIC SLOWED BY 21 BARS. The long-term stochastic gave a sell signal several days before Black Monday in October 1987.

FIGURE 4: DAILY CHART FOR THE OEX FROM OCTOBER 1991 THROUGH JULY 1992 SHOWING THREE STOCHASTIC PLOTS: THE 150/5 (SOLID LINE), 50/5 (DOTTED LINE) AND 13/5 (DASHED LINE). Important turns in the market occurred when all three indicators were either above 80 or below 20.

FIGURE 5: DAILY CHART ALCOA FROM OCTOBER 1991 THROUGH AUGUST 5, 1992, SHOWING THE 150/5 AND THE 50/5 STOCHASTIC PLOTS. A successful buy signal appeared in December and a successful sell was indicated in June. As with most techniques, stop-loss orders can be used to help avoid large losses in case of false signals.

FIGURE 6: CHEVRON (CHV) DAILY (OCTOBER 1992-AUGUST 5,1992) SHOWING THE 150/5 AND THE 50/5 STOCHASTIC PLOTS. A good buy was indicated in March.

FIGURE 7: DAILY CHART BALLY FROM OCTOBER 1991 THROUGH AUGUST 5, 1992, SHOWING THE 150/5 AND THE 50/5 STOCHASTIC PLOTS. The best signal happened with the downturn in late February.

FIGURE 8: DAILY CHART OEX FROM AUGUST 1991 TO AUGUST 1992 SHOWING AS AN

OSCILLATOR THE TIMES WHEN THE 10/5 AND THE 30/5 STOCHASTICS ARE ABOVE 80 OR BELOW 20 (+2 AND –2, RESPECTIVELY). When the oscillator reads either +1 or –1, only the short stochastic is above 80 or below 20.