Due to the substantial growth in international economies, we are witnessing huge increases in volatility and wider than normal daily ranges in most markets as a result of this booming growth. Most countries, from a financial perspective, are now interdependent of each other and this in effect has created an increase in the demand for raw commodities as well as opened the door for new technologies and business opportunities. At times, this demand it has caused strains on the financial community and that has raised demand from speculators trying to capitalize on these massive price fluctuations. Traders from commercials tying to hedge risks to large Hedge funds and small speculators are seeking to profit from these tremendous market moves. As we all know, when there is an opportunity to profit comes risk of loss. Unfortunately many novice speculators have a tendency to be right in calling market moves but have poor timing on entering or exiting the market as prices cycle between highs and lows. The goal of this article is to familiarize you with a technical oscillator tool known as Stochastics. This tool can be instrumental in helping all traders in volatile market conditions filter out between cycle high price points, known as peaks and cycle low points referred to as troughs or corrections. Stochastics is a range based oscillator it is also considered a momentum oscillator. George C. Lane is credited with creating the formula. I had the privilege of working for George back in 1980. His indicator is a popular technical tool used to help determine whether a market is overbought, meaning prices have advanced too far too soon and due for a downside correction, or oversold, meaning prices have declined too far too soon and due for an upside correction. It is based on a mathematical formula that is computed to compare the settlement price of a specific time period to the price range of a specific number of past periods or look back period. The method works based on the premise that in a bull or up trending market, prices will tend to make higher highs and the settlement price, or close, will usually tend to be in the upper end of that time periods trading range, or at least closer to the highs of that “look back” period. When the momentum starts to fade, settlement prices will start to push away from the upper boundaries of the range and the Stochastics Indicator will show that the bullish momentum is starting to change. The exact opposite is true for Bearish or down trending markets. There is Fast Stochastic’s and Slow Stochastics. The difference is how the parameters are set to measure the change in price based on specific time periods. A higher rate of sensitivity will require the number of periods in the calculation to be decreased. This is referred to as a gauge in sensitivity. It enables one to generate faster and a higher frequency of trading signals in a short time period. This is what “fast” Stochastics does and the settings I use are described in this article. There are two lines that are referred to as %K and %D. These are plotted on a horizontal axis for a given time period and the vertical axis is plotted on a scale from 0% to 100%. As you will see from the formula below, %K will be the faster of the two lines and will change direction because the %D line is a moving average of %K.

The formula to calculate the first component, %K: (14 period)

The value of %K =c-Ln/Hn-Ln*100

c=closing price of current period, Ln= lowest low during n-period of time, Hn=highest high during n-period of time and n=number of periods.

The second calculation is the %D (3 period) It is the moving average of %K

It is calculated by: %D=100(Hn/Ln)

HN= the n-period sum of (c-Ln).

The unique feature of the Stochastics reading is it has two functions, a moving average crossover feature and the range based oscillator feature with readings between 0 percent and 100 percent. The main guidelines reflect that readings over 80% indicate a market condition is near overbought and ripe for a downside correction. It helps indicate that a bullish or up trending cycle is nearing completion and that a pause or correction in prices is due. Readings under 20% signals the market is oversold and ripe for a bounce, it shows a bearish cycle or down trend is nearing exhaustion and a pause or reversal rally is to be expected. Traders can manipulate or “tweak” these settings for different markets and when markets are in various volatility conditions. Stochastics is a great indicator to identify turning points; however, I look for more clues within the indicator as well as other confirming criteria’s to trigger an entry into trade. When using Stochastics I look at the indicator to corroborate the timing of a trade or a market turn associated with a change in price action. As stated, this indicator measures the strength or weakness of the market by the current close of the market as it is weighted against an established range of a specific number of past time periods. In a bullish market condition we generally see prices close towards the upper end of the range and closer to the highs. But after a prolonged period of time and price advance, when markets are making their respected highs once we see prices starting to close towards their lows, this is a sign that the bullish trend is exhausting itself. Therefore, when using the fast stochastics settings I look for these conditions to be met to identify a bearish reversal:

§ When the readings are above 80%, and %K crosses below the %D line and both lines close back down below the 80% line, then a “hook” sell signal is generated.

Examine the chart on Apple Inc, (AAPL) in figure “A”. This was right before earnings were released. Notice at the peak in prices, the corresponding point in the stochastics readings warned that the market was in danger of a correction or at the very least a pause.

Despite the expectations for this stock to do well from enormous holiday sales of IPOD’s, the Stochastics readings warned that the market was in danger of a correction. As the large gap shows on the charts, many investors sold on the news. The Stochastics indicator showed the %K line crossed below the %D line when both values were above the 80% level and once both lines closed back down below the 80% line, then a “hook” sell signal kicked in. Subsequently prices continued lower. Here is a great example where a technical indicator may have spared you a loss from buying before an earnings report as the technical conditions were not right for such a set-up.

Here is how I use Stochastics to help me determine if a market is close to a bottom after a bearish downtrend. If you examine the chart on Apple, notice that the market began in a down trend where we see the vast majority of red candles. This shows that prices closed below the open and we see that the closes of each red candle are closer to their respected lows. It is not until we have a wide ranged green candle that shows the market reversed the bearish conditions and closes back closer to the upper end of the range or the highs. What helped alert a trader that a reversal was eminent was the fact that the Stochastics indicator was below the 20% level. After a prolonged downtrend, and a severe price decline fast Stochastics will help you identify a potential bullish hook reversal when:

§ %K and %D readings are below 20%, then %K crosses above %D both lines close back up above the 20% level, then a “hook” buy signal is generated.

This criteria was met in this example as prices began a stellar advance until the market trend or bullish cycle exhausted itself and the subsequent sell signal was generated. We can implement other techniques to confirm the stochastics signals such as Fibonacci support and resistance levels or my preferred market analysis tool based off pivot point levels when prices are in proximity of a targeted support or resistance level. These are rules which will help to make better trading triggers for buy and sell signals. Looking at the next chart in figure B is a 15 minute candle chart on the CBOT mini-Dow contract. The buy signal is triggered once the %K and %D lines both cross over and close back above the 20% line. It also confirms for the first time after the down trend that the market made a higher closing high, meaning that the current bar or candle closed above the prior time periods high, and up towards the highs of the past 5 time periods highs.

which in this case would be at 12535.

In figure B we also see stochastics warned that the market is concluding its bullish trend or cycle high as prices reach near 12575. That would present a potential profitable scalp of 40 points at 5 dollars per point per contract which is $200 dollars on a day trading margin of $500 dollars that most Futures brokerage firms charge, or a 40% return. Let’s apply these concepts to a different market in a different time frame. Figure C shows a weekly chart on Urban Outfitters (URBN). Notice that this stock was in deep sea dive mode plunging from 32.00 down to just under 14.00 per share. But notice the stochastics indicator as %K and %D finally crossed and closed back above the 20% line. A bottom was confirmed as we had strong volume that spiked on the reversal up days.

Stochastics can help your timing on entries and exits by identifying these subtle nuances when the %K and %D values make changes at these 20% and 80% levels. It will also help confirm your trades when using other methods such as volume, candle charts or Pivot Points.

Bullish Convergence

Markets need volatility in order to move and we need markets to move in order to trade. We also need to base our trading plans based on reliable signals. Not all times do the set-ups that trigger an entry work as perfectly as in these past three examples, which is why I have other confirming signals to corroborate timing a trade. Another signal or method I use the stochastic indicator for is to help identify a pattern called bullish convergence. It is used in identifying market bottoms. This is where the market price itself makes a lower low from a previous low but the underlying stochastic pattern makes a higher low. This indicates that the secondary price low is a “false bottom” and can resort to a turn around for a price reversal. The chart in figure D is the CBOT’s electronic Gold market and this chart shows how prices made a secondary low, significantly lower than the primary low which was made in tandem with a secondary higher low in the stochastic indicator.

As you can see a major reversal occurred. One point I would like to make here is if the market is truly bearish one would anticipate that the stochastics would be at least equal or lower in value than that of the primary low. As you can see it is not and it accurately predicted that a false bottom was made resulting in a major turn around in prices.

Bearish Divergence

Another signal is a trading pattern called bearish divergence. It is used in identifying market tops. This is where the market price itself makes a higher high from a previous high but the underlying stochastic pattern makes a lower high. This indicates that the second high is a “weak” high and can resort to a turn around for a lower price reversal.

The example in figure E below is a Holder, another form of an Exchange Traded Fund (ETF) the Oil Industries Holders (OIH). This chart shows how the market makes a secondary high but the corresponding high in the stochastics is at a lower level then the price charts primary high point.

This pattern can alert you that if the market appears to be ready for a new bull trend, the stochastics readings should be equal or higher than the primary peak level. Notice the %K and %D both cross over and close back beneath the 80% line, a sell trigger is generated. That signal warns of an impending prolonged downtrend of substantial proportion. Therefore, it is important to monitor for Divergence Patterns.

The Bearish Divergence Pattern signals forecasts that there is an impending reversal ready to occur in a market price. As I mentioned previously, one can anticipate and get ready to place an order to act on the signal but you should not act until the confirmation of a lower closing low triggers the entry, which would be to act on the close or the next open. Here are rules to guide you to trading a stochastics bearish divergence pattern:

The first peak in Prices should correspond with a peak in the %K and %D reading above the 80% level.

The second peak in stochastics should be lower than the first peak and it should correspond to a significant higher secondary price high point.

If the secondary Stochastics peak is less than or under the 80% level this signals a stronger sell signal.

Prices should make a lower closing lower to confirm a trigger to enter a short position. Enter on the close of the first lower closing low or the next open. The protective stop should initially be placed above the high of the secondary high.

Lets examine the chart on Google (GOOG) in figure F. As you can see the market formed a wedge consolidation pattern. The theory for wedge patterns states that the breakout generally is in the direction of the overall trend. In this case prior to the wedge being formed the trend was up.

Now if we apply what we have leaned from Stochastics and use the rules described above, first of all we would see that prior to the breakout of the wedge pattern marked point A, the Stochastics was indicating a cycle low, or that a bottom was forming. After prices achieved the bullish breakout objective, we see a double top formed as stochastics was above the 80% level. The second peak in stochastics was lower than the first peak as it corresponded to the secondary price high point. The secondary Stochastics peak was significantly less than or under the 80% level, as the rules states, and it did generate a strong sell signal. This would have been a good clue to tighten stops, implement a covered call strategy, sell short or simply get out of a long. Now until the stochastics generates a buy signal or highlights when a cycle low will be made an investor can stand on the sidelines until a buying opportunity presents itself.

Just as with any other technical tool if you know how to use it and under what market condition it can be a great friend in helping you make consistent trading decisions. You are using it under certain parameters and are follow a rule based method rather than trading from the seat of your pants or on hunches. I wish you well in all you trading endeavors and if you wish to learn more about how to use stochastics with other indicators or charting techniques may I suggest you read my second book Candlestick and Pivot Point Trading Triggers: Setups for Stock, Forex, and Futures Markets. It comes complete with a CD-ROM and a pivot point calculator.

All the best,

John Person