This technical indicator measures a shares momentum. What
momentum means is, what is the share price doing, in relation to past data.
This is one of the most popular indicators that traders make use of, and can be
highly effective if used in the right way. The indicators output can be seen
below.
The
stochastic oscillator its self is bound between 0 and 100 and moves within this
range. In the picture above one can see two horizontal lines one red and one
blue. These indicate the overbought and oversold regions. They are placed at
the 20 and 80 mark on the vertical axis. When the stochastic oscillator moves
below the blue line at 20 on the vertical axis a potential buying region is
indicated to the investor as the share is becoming oversold. Likewise when the
stochastic oscillator moves above the red line at 80 on the vertical axis, this
indicates to a potential investor that the share is becoming overbought and
this is not a good opportunity to enter into the trade.
The
first technique that will be discussed is the application of the moving average
to the stochastic to find potential trade entries and exits. In essence the
moving average provides a smoothed version of the stochastic data as it takes
the average of several values and uses that to create points which form the
moving average version of the stochastic. The chart below makes use of a slow
stochastic with a 7 day moving average applied. The different types of
stochastics will be discussed in the latter of this page
The moving average is used to show the investor if the
stochastic is increasing or decreasing relative to the past data. In an upward
trend of the stochastic when the share price is above the moving average this
indicates that there is an increase in momentum relative to past data, likewise
when the stochastic data is below the moving average for an upward trend this
indicates that the momentum is decreasing relative to past data. In the case of
a downward stochastic movement. If the stochastic is below the moving average
this means that the downward movement is strengthening relative to past data.
However, if the stochastic is above the moving average this indicates that the
momentum is decreasing relative to the moving average.
Thus
far we have established what the buy and sell zones are and where they are
placed, as well as establishing the application of the moving average to the
stochastic. Using these tools the output is as seen in the graph below.
As
previously established when the stochastics are below the moving average in a
downward trend this indicates that there is a strong movement down but when the
reverse is in play where the stochastic is above the moving average this
indicates that the momentum is increasing relative to the moving average. Using
this logic, the buying points seen in the graph are selected where the
stochastic intersects the moving average this is the point at which the
decreasing momentum is changing to increasing momentum. Looking at “BUY ZONE 1”
and “BUY ZONE 3”, this method worked very well in finding a good entry point
into the trade however the method does not always deliver optimal entry points
which can be seen in “BUY ZONE 2” where the buy signals were triggered, but the
share price continued a sideways movement.
Now to use the same logic but to identify potential sell
regions. Using the moving average method the selling price was chosen when the
stochastic moves from a position above the moving average intersects the moving
average and moves below the moving average. This is because when the stochastic
is above the moving average the share momentum is still increasing upwards
relative to past data but when the stochastic intersects and cuts through the
moving average the momentum is decreasing relative to the past share data. Looking
at “SELL ZONE 2” and “SELL ZONE 3”, this method worked very well in finding a
good exit point out of the trade. Like the buy trigger the sell trigger to is
not always triggered at the optimal sell point as seen in “SELL ZONE 1” with
the red vertical line in the first sell trigger. Here a sell was triggered but
the share continued to move upwards with the optimal sales point being
triggered at the second sell trigger.
Changing
the Stochastic settings can have a significant effect on the results that the
stochastic displays. Knowing what settings to use can make a significant
difference to the buy and sell signals that are displayed to the user. The
three settings that will be discussed will be fast, moderate and slow moving
Stochastics.
The
slow stochastic is used to give a less sensitive reading of the momentum. Slow
stochastics will usually provide less buy and less sell points as opposed to
the fast and moderate stochastics, but the points at which the potential buys
and sells are triggered will tend to be better entry and exit points. The
potential problems with the slow stochastic is that it can sometimes show a buy
or sell signal that its slightly too late or later then the optimal point. The
settings that have been proven to work well are to set the stochastic to a 21
period with a 7 day moving average.
The medium setting is used to get a balance between the fast
and the slow stochastic, traders will use this if they want a little more
sensitivity in their stochastics as this will give more potential buy and sell
signals. The settings that have been proven to work for a medium outlook are to
set the period to 14 days with a 3 day moving average. An example of the 14
period stochastic with a 3 day moving average can be seen below
The
last setting that will be discussed is the fast setting, this is used when a
high sensitivity is desired. The setting will give the most potential buy and
sell signals. The points at which these signals will be triggered is geared to
faster trading, especially day trading where a high volume of signals is
needed.
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