Stochastic Oscillators Defined

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The CNX Smallcap Index has been struggling for more than a year now and wealth has been destroyed substantially as the index is still almost 24% negative over a year’s time frame. While momentum has picked up in the last one week (4.23% up- the highest across asset classes), doubts still remain whether this signifies a bottoming out of smallcaps – or just a whipsaw before proceeding lower? The Stochastic Oscillator may therefore be the indicator to watch for , as and when a buy signal emerges!

Defining a  Durable Rally

A bottoming out and reversal would typically mean that prices are beginning to close higher, towards the near term highs more often than not – meaning demand is strong – against a situation where closing prices were typically ending near the bottoms of a price range over a period- which is what is happening to the index last 1 year.

Intuitively, we typically have reference prices in  mind and strength is often compared in terms of actual price versus such reference points. What if we had an indicator to capture this simply?

This is where the Stochastic Oscillator comes in – The theory behind it is fairly basic: The price of a security closes at its high in a market with an uptrend, and similarly, closes at its low in a market with a downtrend.The Stochastic Oscillator compares where a security’s price closed relative to its price range over a given time period.

The Stochastic Indicator, developed by George C. Lane in the late 1950’s is one of the most popular members of the Oscillator family in technical analysis. In an interview, George Lane said that he  liked this indicator as it didn’t follow any price or volume; rather it follows the speed of price momentum and as a general rule, the momentum changes direction before the price changes.

Using this momentum indicator, a trader can gauge the strength of the momentum and interpret overbought and oversold conditions of a security, currency or an index. Momentum oscillators such as stochastics can give clues when the momentum is slowing down or picking up.

Calculating the Indicator

Lets say a stock is trading at Rs 60 and its highest price for the period is Rs 100 and lowest is Rs 30. To calculate the first number  in a stochastic indicator, called %K, one must first find the security’s placement within the highest-high and lowest-low over the last 10 days.

In this example, it would translate to calculating it as follows : At Rs 60, the price is Rs 30 higher than the lowest price (60-30) and the price range from  the Highest to Lowest is Rs (100-30)= Rs 70. At Rs 60 therefore, the %K indicator is at ((60/70)*100)=  85.7

In  other words, the security closed at a price which is within 14.3% of its highest price during a certain trading period of lets say 14 days or weeks.

Mathematically , the formula is expressed as ;

%K = 100[(C – L14) / (H14 – L14)]

Where,

C = the recent closing price

H14 = the highest price traded during the same 14 periods

L14 = the low of the 14 previous trading periods

The Stochastic Oscillator therefore always ranges between 0% and 100%. A reading of 0% shows that the security’s close was the lowest price that the security has traded during the preceding x-time periods. A reading of 100% shows that the security’s close was the highest price that the security has traded during the preceding x-time periods.

As one can observe, this oscillator can be very sensitive to fluctuations in market prices, and therefore the level of fluctuation in the indicator needs to be smoothed somewhat by altering the time period being measured. One does this by typically taking 14 periods and then taking an average of the %K over 3 periods which is called the %D indicator, a moving average of %K

On  charts therefore, the Stochastic Oscillator is displayed as two lines. The main line is called “%K.” and the second line, called “%D,”. The %K line is usually displayed as a solid line and the %D line is usually displayed as a dotted line.

A representation if the CNX Smallcap Monthly Index as well as the Oscillator is shown below (as of March 1, 2019) – as well as the %K and the %D lines. (The trough on the oscillator is clear, lasting almost 6 months, and one is therefore on the lookout for a buy signal on this oscillator.)

The Uniqueness

Instead of using all indicators that are almost always derived from the end of day or closing prices, the use of a tool like stochastics can add more information and  value to decision making as it compares prices to the highs, lows and  ranges in a single number.

Also, unlike most other indicators, It is a leading indicator as it gives us advanced signals before it is reflected in the price behaviour.

Interpreting the Oscillator

The major takeaways from Stochastic include overbought and oversold zone, bullish and bearish divergences (which help in anticipating future reversals) and crossovers.

Three popular methods of interpreting signals include:

  1. Buy when the Oscillator (either %K or %D) falls below a specific level (e.g., 20) and then rises above that level. Sell when the Oscillator rises above a specific level (e.g., 80) and then falls below that level.
  2. Buy when the %K line rises above the %D line and sell when the %K line falls below the %D line. Similar to how we do it with fast and slow moving averages.
  3. Look for divergences. For example, where prices are making a series of new highs and the Stochastic Oscillator is failing to surpass its previous highs.

Important Notes

The Stochastic Oscillator can be better analysed in multiple time frames as it will provide better and relatively earlier confirmation. Say if you are analysing Stochastic in the daily chart, you need to look into the smaller time frame say hourly or 4 hourly in order to get early entry into the trades.

Also, only take signals in the direction of the trend and never go long when the Stochastic is overbought, nor short when oversold.

Importantly, the shape of a Stochastic bottom gives some indication of the strength of rallies- A narrow bottom that is not very deep indicates that bears are weak and that the following rally should be strong. A broad, deep bottom signals that bears are strong and that the rally should be weak. Similarly for tops especially during corrections – High, wide tops indicate that bulls are strong and the correction is likely to be weak.

Of course, in smallcap stocks, where liquidity is often scarce and prices can be very volatile, this indicator should not be used alone – and volumes are also very important alongwith price action. Keep this indicator mapped on your charts however – as and  when the prices begin behaving the way the bulls want, you will see the picture loud and clear!

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