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”. You can see this detailed in the example chart below as the values displayed are (14(3), 3). 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.
You have undoubtedly noticed the similarity of techniques used in trading both Stochastics and the RSI. This allows you to easily use them as a means of confirmation for each other. Just be sure to use the same analysis periods. I will explore this concept further in the chart below.