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

Trading stocks with stochastics

Next, a lesson from moving averages is applied. Moving averages are simply an average calculation over a set range. They are helpful for smoothing out noisy data streams and providing a reference for current data changes. As the range moves through time and each recent value is added, the oldest value is dropped. This way, the range remains the same. For stochastics, Lane calculated a three-period moving average of %K and plotted this on the same graph as %K. He called the three-period average %D.

The %D line also is called the trigger line. When the faster moving and noisier %K crosses above or below %D, it is considered significant, particularly when analyzed in the context of actual price action.

The stock market is rife with examples of stochastics correctly identifying market turns. Dell Inc. (see "Turn by turn") provides several.

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The chart shows a long-term daily price chart of Dell Inc. The stochastics indicator uses the default setting of 14 days. The rectangle identifies an area where it worked particularly well to capture intermediate-term gains. The low of the period, on Dec. 8, 2009, was $12.74. The high, when stochastics marked the end of the move on Dec. 28, was $14.81.

Let’s use these data to demonstrate the calculation of the oscillator near the end of the move. The closing value on Dec. 28 was $14.6. Putting this into the formula, we get:

%K = 100[(14.6 – 12.74)/(14.81 – 12.74)]

%K = 89.85

Low readings (below 20) indicate that price is near its low for the given time period. High readings (above 80) indicate that price is near its high for the given time period. Because our reading is well above 80, we could say that Dell Inc. was overbought at that price based on recent price action.

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