Table Of ContentStocks & Commodities V. 11:3 (144-146): Stochastics Indicators And Trading by David Lundgren
Stochastics Indicators And Trading
by David Lundgren
Here, first-time STOCKS & COMMODITIES contributor David Lundgren reminds us that the stochastics
indicator is just a guide to understanding the trend for trading.
S
tochastics, or any technical indicator for that matter, is just a mathematical formula that processes data
from one form into another. That's all it is. It is not the crystal ball that you have been in search of all
your life. It is simply a guide (and a very effective one at that) used to either confirm or contradict other
analyses of the most important data of all — price action.
Before you consider a technical indicator, first you must do your homework on price action, which means
studying hourly, daily, weekly and monthly bar charts of the market in question. This must then be
supplemented by studying intermarket relationships that affect the market that you are trading. Only after
you have established a directional bias for this market should you incorporate stochastics and other
technical indicators into your analysis, looking for signals that either confirm or contradict your expected
price trends.
If your price analysis is confirmed by stochastics, then you can trade with more confidence in your
outlook. But if the stochastics indicator contradicts your conclusions, then you should either stay on the
sidelines and wait for the stochastics indicator to agree with you or simply trade in the direction of trend
analysis, but with less exposure than you would otherwise take on. Never trade against your trend
analysis just because stochastics contradict what you are observing.
STOCHASTICS FORMULA
First, stochastics indicators are designed to inform you when an advance or a decline has become
Article Text Copyright (c) Technical Analysis Inc. 1
Stocks & Commodities V. 11:3 (144-146): Stochastics Indicators And Trading by David Lundgren
overbought or oversold. The formula for stochastics is as follows:
(cid:230) Current close-Lowest Low (cid:246)
%K=100(cid:231) n (cid:247)
Ł Highest High -Lowest Low ł
n n
The n period is the number of lookback days selected by the user.
(cid:230) (cid:229) 3 (cid:246)
(cid:231) (cid:247)
Current close-Lowest Low
(cid:231) n (cid:247)
%D=100(cid:231) j=1 (cid:247)
(cid:231) (cid:229) 3 (cid:247)
(cid:231) Highest High -Lowest Low (cid:247)
n n
Ł ł
j=1
%D is a smoothed version of %K and is used as a crossover method to indicate trend.
Intuitively, what this formula attempts to measure is where today's close is relative to the highest high
and the lowest low recorded over the past n days. If %K equals 100, then price is trading at the highest
level in n days. If %K equals zero, then price is at its lowest level in n days. Because it is obvious that the
close must be above the lowest low and below the highest high, the stochastics reading will always fall
between zero and 100. Because each individual close can be quite random, the pure stochastic number
can be very volatile. Typically, this volatility is smoothed out by smoothing %K with the above formula,
resulting in %D; this version is called fast stochastics. There is an additional version where %D is
relabeled %K and is smoothed with a three-period simple moving average, which is called slow
stochastics.
STOCHASTIC: THREE WARNINGS
Typically, stochastics give at least two warnings (sometimes three) that a trend is nearing an end. The
first warning comes when stochastics reach an overbought reading (a %D reading above 80) or an
oversold reading (a %D reading below 20). Of the three warnings, this is the least important. An
overbought reading, for instance, can last for years before a meaningful correction unfolds. An example
can be seen in Figure 1. Here, we see that overbought readings existed on stochastics during three very
powerful advances in the Eurodollar — 1984 to 1987; 1988 to 1989; and 1991 to late 1992. Anyone who
ignored price action and attempted to sell Euros short did so at their own financial peril. Once an extreme
reading is registered, traders should be more concerned with the direction in which the stochastics are
headed than whether they are overbought or oversold.
The second warning comes when %K either crosses down over %D from an overbought level or crosses
up through %D from an oversold level. This warning is more important than a simple extreme stochastic
reading, because it suggests that the trend is tiring. At this point, partial profits should be taken, and
trades contrary to this crossover signal should be avoided. However, this signal does not mean that the
trend is over. Once again looking at Figure 1, we see that several crossovers occurred in overbought
territory, but the trend continued upward nonetheless. At this point your technical analysis of price action
becomes crucial. Is a reversal or topping chart pattern forming? Is volume heavy on price weakness? Are
related markets confirming the weakness seen in the market you are trading? If the answer is "no" to any
of these questions, chances are that the is trend is not over yet.
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Stocks & Commodities V. 11:3 (144-146): Stochastics Indicators And Trading by David Lundgren
THE FINAL WARNING
After the first crossover occurs, stochastics are then set up to generate the third and final warning that the
trend is over. This final warning is known as a divergence. There are two types of divergences. The first
is bearish, which occurs after stochastics give their first crossover in overbought territory. Prices bottom
and break to new highs, and fast enough so that stochastics do not have time to bottom and break to new
highs as well (Figure 2). At this point, traders should scale further out of their long positions and avoid
adding to that long position. The second type of divergence is bullish. This is simply the inverse of a
bearish divergence.
But what if stochastics do break to new highs? If stochastics confirm the new high in price by setting a
new high of their own, then chances are that, following the next market correction, at least one more high
will be set by price. Figure 1 illustrates this perfectly. Each time the Eurodollar contract set new highs,
stochastics did the same. Thus, even though the advance was overbought as per stochastics, new highs
were probable until a bearish divergence was signaled. So in essence, if price and stochastics break to
new highs together, it is bullish, no matter if the %D reading is above 80.
Now that you have been given three warnings that the trend is
over, do you trade on the assumption that the market will reverse?
No. Price action takes precedence over these stochastic signals.
Now that you have been given three warnings that the trend over, do you trade on the assumption that the
market will reverse? No. Price action takes precedence over these stochastic signals. You must first do
your homework, asking the same questions: Is there a reversal formation? Does volume confirm a
reversal of trend? Does intermarket activity suggest that your market should reverse?
Figure 2 shows a perfect example of why you must wait for price action to confirm the stochastic signal.
In the figure, a bearish divergence on the monthly stochastics is very clear. However, after prices tested
the bottom of the channel, they resumed their uptrend despite the bearish divergence on stochastics. In
this particular case, traders should have done one of two things: Either go long at channel supports,
keeping trading size to a relative minimum; or remain flat altogether and wait for stochastics to turn,
bullish again. The fact is, this bearish divergence never really amounts to anything until price action
confirms it by breaking down out of the channel.
STOCASTICS SUMMARY
Above all, keep in mind that price action is most important of all. Stochastics are just a tool in a trader's
toolbox, used to confirm or contradict trend analysis of price action. Until prices behave in a manner that
is confirmed by a stochastic signal, the signal is nothing more than a warning. If the market trend runs
contrary to a stochastic signal, then wait for stochastics to agree or trade a minimum size in the direction
of the trend.
David Lundgren, 508-832-2002, publishes Trading Prophets, a daily faxed analysis of the Treasury bond
market.
References Copyright (c) Technical Analysis Inc. 3
Stocks & Commodities V. 11:3 (144-146): Stochastics Indicators And Trading by David Lundgren
ADDITIONAL READING
Murphy, John J. [1986]. Technical Analysis of the Futures Markets, New York Institute of Finance.
FIGURE 1: WEEKLY EURODOLLAR FUTURES. Here, the slow 14-bar version of the stochastics
indicator reached overbought levels early during each of the strong upmoves. The high readings of the
stochastics indicator was a sign of strength.
Figures Copyright (c) Technical Analysis Inc. 4
Stocks & Commodities V. 11:3 (144-146): Stochastics Indicators And Trading by David Lundgren
FIGURE 2: T-BONDS MONTHLY. In September 1992, the Treasury bond market reached new highs
while the stochastics indicator failed to make new highs. This signaled a possible reversal of the rally
that began in 1990. However, the T-bond market needs to break the long-term uptrend line to confirm
the warning from the stochastics indicator.
Figures Copyright (c) Technical Analysis Inc. 5
