Technical Analysis - Stochastics Tutorial
George Lane found another way to track market momentum by following the relationship between a market's closing price and the extremes of its recent range. A bull market should consistently see closes near the high it's recent range. A bear market should see closes near the range's lows. A market's momentum wanes as the day's closing prices move towards the midpoint of its recent range. As such, traders assume that the stage is being set for a reversal as a market's momentum begins to wane. Stochastics provide us with a way to both quantify and chart these statistics.
As you can tell by the equation below, Stochastics describe the relationship between a market's recent extremes and its relative daily close as a percentage value. Mr. Lane labels his descriptive values as a %K and %D. The %K value is described as follows:
%K = 100 [(C L14) / (H14 L14)]
Thus, we calculate what percentage of the recent range the close for the day falls within. The result here is an extremely volatile value. Hence, it is termed a "Fast Stochastic". To generate a trade signal, traders plot a smoothing 3 period moving average of this %K value and trade it as one may trade a moving average crossover system. This smoothed value is called a %D. A more reliable trading methodology would be to further reduce this volatility by taking another 3 period moving average of %D. This calculation yields a "Slow Stochastic". Thus, we have the original 14 period calculation smoothed by 3 period moving average and then by an additional 3 period moving average. The resulting values can be graphed against daily prices. Also, as with most other technical studies, Stochastics exhibit self-similar characteristics across a wide range of time frames. Thus, they may be applied to monthly, weekly, daily, intraday and even tick charts.
A chart of Stochastic values reveals a considerable amount of information about a market when compared with overall price action. The end of a prolonged rally may be foretold as a Stochastic value fails to follow the price action to new highs, much like a bearish divergence with an RSI indicator. Look for the faster %K to cross over the slower %D as the indicator tops out and crosses below the overbought 80 level. A 20 level is considered to be oversold. This compares to the 70 and 30 levels used with an RSI indicator.