Randomness and the Stochastic Indicator

Trivia question: who said “If you visualise a rocket going up in the air – before it can turn down, it must slow down.’ I agree, it doesn’t sound extremely profound, mostly just common sense. However, the same person added: “Stochastic measures the momentum of price. Momentum always changes direction before price.” The author is George Lane, a technical analyst enthusiast and teacher, who developed the stochastic indicator back in the 1950s.

The term “stochastic” means randomness, as in involving a random variable. Was Lane’s purpose to eliminate the randomness from trading decisions or did he have something else in mind when he named his indicator?

The Concept

The stochastic indicator is based on the premises that during uptrends, the closing prices tend to gravitate near the highs of the period, and during the downtrends, the closing prices tend to stick closer to the low of the period. This pattern holds particularly well when trends are running out of steam.

The Lines

The stochastic indicator has two lines: %K and %D. According to Lane, those capital letters were assigned arbitrarily, although nowadays traders associate the %K line with “quick” and D line with “dawdle.” In this context, the stochastic indicator attempts to time a market’s turning points by comparing closing price with the price range. The %K line is the result of placing current closing prices within a price range. %D is nothing else but a moving average of %K, a 3 period moving average to be more precise. A simple moving average is calculated by summing the closing values and dividing the sum by the number of periods. So far, the only randomness we have uncovered pertains to the names of the lines, but let’s see if it ends here.

Overbought & Oversold Levels

%K and %D lines oscillate between 0 and 100, with overbought and oversold thresholds at 20 and 80. Those lines serve as guides to gauge overbought and oversold conditions. Generally speaking, if the stochastic is below 20 or above 80, it means that a market is trendy. It does not mean that you should sit on the sideline if you haven’t entered a trade already or you should exit if you are into a trade. Stochastic overbought and oversold levels do not mean reversal! It means that the momentum of the trend is strong; therefore, a reading above 80 is bullish and a reading below 20 is bearish. A simplistic approach, according to Lane, is to sell after the indicator moved below 80 and buy after it moved above 20. A stochastic reading at the extremes, 0 or 100, shows extreme bearishness or bullishness, not that the trend is over.

Divergences

Divergences point towards possible turbulent times ahead, and you can easily spot divergences with the stochastic indicator. A divergence takes place when the price movement of the underlying (stock for example) is not confirmed by the movement of the indicator, meaning that there is at least a stronger probability of a pause in trend or a correction in the near term. For instance, if a stock makes a higher high, but the stochastic does not, it is a warning sign that the trend is running out of steam, and it may be prudent to look for exits. As mentioned previously, an extreme stochastic reading by itself does not necessarily mean that the trend will reverse.

Crossover Signals

What do %K and %D line crossovers tell us? Just like moving averages crossovers, when the quick line, in this case %K, crosses above the slower moving average, in this case %D, it is considered a buy signal. Conversely, when %K crosses below %D it is considered a sell signal. As mentioned previously %K is not a moving average, only %D is, but the principle is the same. As you know, not all signals are created equal; some are more valuable than others. For example, a crossover of K above D, when both lines are above 80 is a confirmation of the strength of the underlying trend. Conversely, a crossover of the K below D at a less than 20 reading is a confirmation of the weakness of the trend. However, a market can pause while stochastic reading doesn’t change. When resuming, a crossover in the direction of the trend reinforces the view.  New signals in the neutral (20 to 80 zone) after a trend is resuming are more valuable. Don’t expect that the stochastic indicator is going to sit below 20 at all times during a downtrend since stochastic can easily move to overbought while prices are not changing much during a downtrend. The reason that the stochastic indicator shows the location of the current price in relation to a price range during a certain period of time.

One of the most annoying experiences for a trader is to watch a trend develop in a market, while the indicator is giving conflicting crossover signals. This is the major gripe with the stochastic indicator (please see chart below – Frustrating Times). The indicator lingered above the overbought 80-level, while %K and %D were crossing each other periodically, giving a bunch of false crossover signals. Under those circumstances, some would say that the name suits this indicator.

Settings

The indicator comes with standard settings of 14,3,3; however you should customize it according to your trading time frame.  It shouldn’t be a one-size-fits-all type of indicator. When I research a new trading strategy, I always tweak the settings according to my time frame. For example, if I use a stochastic indicator on a 60 minute chart, then I apply 5,3,3 setting for intraday trading, since the 14,3,3 setting is too slow. However, the default setting may be too fast if the time frame is longer, for which a more appropriate setting is 21,3,3. Of course, you could look at other combinations as well. It is imperative to make sure that your new and improved indicator works well on more than one stock, pair, or market. If it does not, consider it a warning sign that you have probably curve-fitted the indicator and the relationship between the stochastic indicator and the market is not going to hold for too long. Unfortunately, there is no such thing as a perfect indicator.  Also, as is the case with most trading strategies, you may want to use this indicator in conjunction with other indicators, such as Elliot Wave, and consider other time frames. For example, a signal on daily should be confirmed by a signal on weekly.

“Frustrating Times”: look at September through mid October back in 2010. The stochastic is above 80, while K and D are crossing quite frequently. This is exactly the annoyance traders are experiencing while trading trending markets and using this indicator.

“Timely Sell Signal” on November 05, 2010 & December 31, 2010

Stochastic is at high level, K crosses below D and the correction begins.

“Divergence”

During late March and the beginning of April 2011, although AUD/USD made new highs, the stochastic indicator did not participate with the same enthusiasm. This is a classic example of divergence.

Undoubtedly, the stochastic is a useful indicator in a trader’s toolbox, however I prefer RSI and MACD for the reasons outlined above.