Monday July 16, 2007

Slow Stochastic 

Using the Stochastic oscillator we can compare the current stock price to its overall price range over a specified period of time. The theory of the stochastic indicator is based on the principal that in an up trending market, stocks tend to close near their highs & in a downward market stocks tend to close near their lows.

We use the stochastic indicator to plot two lines on a chart with the values from 0 to 100. These are the %D & %K with the %D line being the more significant of the two. If the readings are above the 80 line then this signifies that the stock price is nearing its high & will reverse soon. If the readings are below 20 then this would mean that its at its lowest point.

Chart courtesy of StockCharts.com

In a Ranging market go long on bullish divergence (on %D) where the first trough is below the oversold level.

Go long when %K or %D falls below the oversold level & rises back above it.

Go long when %K crosses above %D

Go short on bearish divergence (on %D) where the first peak is above the overbought level.

Again go short when %K or %D rises above the overbought level & then falls back below it

Finally go short when %K crosses below %D

In a trending market the shape of the stochastic bottom can give you some indication of a rally. If the bottom of the stochastic indicator is narrow but not very deep, this indicates that the following rally should be strong. If the bottom is deep & broad then this means that the rally should be weak.

We can also apply this to the tops of the stochastic indicator. If the tops are narrow then this means that the bulls are weak & that a correction is likely to follow. If the tops are high & wide then this indicates that the bulls are strong. Remember to get the most out of stochastic indicators make sure you know which market you’re trading in i.e. Ranging or trending.

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