From the June 01, 2011 issue of Futures Magazine • Subscribe!

Trading stocks with stochastics

Technical analysis is a science of forecasting the price of tradeable markets based on price, volume and open interest data. Although those two variables — price and volume — imply a rather limited scope, hundreds of formulas and techniques have been developed to uncover their secrets.

These tools fall into two general categories: Pattern recognition and indicators. A chart pattern is formed within a chart when prices are graphed. Typically, patterns naturally occur and repeat. They are based on the visual interpretation of the data. Indicators, on the other hand, are less esoteric. They’re derived from mathematical formulas and are used to forecast a stock or commodity’s momentum, direction, etc. While the calculation is relatively fixed, the interpretation generally is open to opinion. As such, while they are hard-coded technical indicators, stochastics tend to be used in a discretionary way. (For a close look at stochastics systematic application in the gold market, as well as additional guidance on how to apply, and not apply, this indicator, see "Trading stochastics in context".)

Technical indicators fall into two broad categories: Those that are designed to lead the market and forecast price moves, and those that are designed to lag the market and facilitate post-move analysis. The relative strength index and stochastics are designed and interpreted as leading indicators. Examples of lagging indicators are moving averages or moving average-based indicators, such as moving average convergence-divergence. Typically, leading indicators work better in range-bound markets, while lagging indicators work best in trending markets.

Stochastics is a momentum indicator that signals a reversal in price momentum near key levels, ideally allowing you to enter the market with accuracy for bigger profits. George C. Lane developed the tool in the late 1950s.

Lane has said that the stochastic oscillator "doesn’t follow price, it doesn’t follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price." If that description is true, then stochastics should provide a valuable clue to future price direction.

The stochastic oscillator begins with a calculation of what percentage a security’s closing price is of its price range over a given time period, which is 14 periods (minutes, hours, days, weeks, etc.) by default. The formula to calculate that percentage, which is defined as %K in Lane’s terminology, is:

%K = 100[(C - L14)/(H14 - L14)]

Where:

C is the last traded price at closing.

L14 is the lowest traded price in previous 14 trading sessions.

H14 is the highest traded price in previous 14 trading sessions.

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