Strategy and Technical

In essence the %K is therefore calculating what the price range has been over the past x periods and then takes how far the current close is from the lowest point as a proportion of this. So if the current close is close to the bottom of the last x days' price range the value of %K will be small. The %K actually used in the Slow Stochastic Oscillator takes %K from the above formula and smooths it with a 3-day SMA to give Slow %K.

%D acts as a signal line and is a Slow%K smoothed again with a moving average. When the %K line crosses the %D line from below this can often be taken as a buy signal as it is indicating that the more immediate price action is breaking above the average.

As a range bound oscillator, the Stochastic Oscillator makes it easy to identify overbought and oversold levels. The oscillator ranges from zero to one hundred and no matter how much a financial security increases or decreases in price, the Stochastic Oscillator will always fluctuate within this range. Traditionally, reading above 80 are treated as over-bought and reading under 20 are treated as over-sold although often 75 and 25, respectively are used by traders.

An illustration of the stochastic indicator is shown in Figure 1 where the period used is 14 days.

Figure 1.

In this simple example the stochatics highlight three key turning points and demonstrates a couple of simple strategies for trading with stochastics.

• Buy when both lines are above the oversold level and rising - in choppy markets this tactic can work well in both directions (i.e. also for selling when both lines are below the overbought line and falling). For trending markets it is, as always, best to trade in the direction of the trend only.
• Buy when the fast %K crosses %D from below.When the cross happens below the oversold line then this generally has the most potential but it is important to wait until the line actually move out of the oversold area to confirm the momentum. This works in reverse for sells.

Points A and C in Figure 1 show cross overs in the oversold area followed by a period where both lines are above oversold and rising generating a buy signal. The reverse could be deduced from Point B, although given that that Glaxo was in a fairly sustained uptrend in the second half of 2009 (and went on to above 1340p by year end) this particular bet would have been much less advisable.

Care When Using Stochastics

This indicator can create signals for false buys and sells so is best used in conjunction with other tools and patterns to confirm the interpretation. Using oscillators in isolation can be very risky.

Momentum oscillators such as this are best used when prices are relatively choppy (i.e. moving up and down within a fairly defined range). If a price is subject to a strong sustained uptrend or downtrend, then although the stochastics may say that the intrument is overbought or oversold the strength of the trend may well continue to take the price higher or lower respectively.

The fact that a market is overbought does not necessarily mean that the price direction will change. In fact, in an upwardly trending market it is often right to be long when both lines are in the overbought area but haven't turned lower.