Hello Again, Sleuths,

In my last column, I began a review of the Stochastic Oscillator, one of my favorite technical indicators and one of the three main components of the MST Trader trading system. I discussed the purpose for the indicator, the concept behind it and how it’s constructed. Well, that’s all fine and good. But you don’t read my “Technical Tuesday” columns to learn how to construct a Stochastic Oscillator, do you? I didn’t think so.

Now, I believe it’s important to have at least a passing idea of how an indicator is put together so you have an intuitive feel for how to best use it. But we’ve covered that ground. So today let’s move on to the good stuff — namely, how to deploy the Stochastic Oscillator to make money.

However, before we discuss trading setups and some different ways to analyze Stochastic Oscillator patterns, I need to review one other point about this indicator with you. So please indulge me — it’s important. And it will prevent you from getting confused if you are going to be using the Stochastic Oscillator for the first time as part of your trading or investing efforts. I mentioned this point in my last column. So I’ll get right to it — and I’ll be brief.

The Stochastic Oscillator: The Three Oscillators

As you may recall, in my Nov. 8 column I stated that many traders and investors found that the Stochastic Oscillator — as originally formulated by its inventor, George Lane — was too volatile. This volatility resulted in the indicator flashing signals that too frequently — and often too inaccurate. To address this problem, two variations of Lane’s original version were devised. In order to differentiate the newer variations of the Stochastic Oscillator from Lane’s initial creation, the original version of the indicator is now usually referred to as the Fast Stochastic Oscillator — or the Fast Stochastics, as it’s even more commonly called.

One of these variations is known as the Slow Stochastic Oscillator — or Slow Stochastics. This particular variation on Lane’s original creation is the version of the Stochastic Oscillator I use in the MST Trader. And it’s also the one that I employed to analyze the Russell 2000 Growth and Russell 2000 Value indexes in the Sept. 13 and Oct. 25 Technical Tuesday columns.

The Slow Stochastics is constructed by smoothing both the %K and %D lines of the Fast Stochastics. This smoothing process is the same as the one employed to create the %D line of the Fast Stochastics from the %K line. Just as is the case with the Fast Stochastics’ %D line, a three-period simple moving average has typically been used to smooth out the data for both the %K and %D lines of the Slow Stochastics. This smoothing results in the %K line of the Slow Stochastics being the equivalent of the %D line of the Fast Stochastics.

I use a three-period moving average in the MST Trader to smooth the Slow Stochastics’ lines. And I typically use 14 for the number of %K periods — a very commonly used time frame for the Slow Stochastics — especially on daily charts. But I have employed other time periods in my trading career. So feel free to plug in whatever time period you think will best suit the time frame you are analyzing and the type of signals you need.

The Full Stochastic Oscillator — or Full Stochastics — is essentially the same indicator as its Fast and Slow cousins. However, this version has one minor twist. In addition to the %K and %D lines, the Full Stochastics introduces a third parameter — a moving average of the %K line. This third parameter is created by selecting a numerical value to employ as a smoothing factor to create a moving average out of the data that make up the %K line. This smoothing is similar to the process used to construct the lines of both the Fast and Slow Stochastics. This third parameter is located in the middle of the indicator –– i.e., between the %K and %D lines. Although this version of the Stochastic Oscillator sounds more complicated than the other two varieties, it is used in essentially the same ways.

When compared with the other technical indicators we’ve previously discussed — Moving Averages and the Relative Strength Index — the number crunching necessary to construct a Stochastic Oscillator is much easier on the brain. Nevertheless, if mathematics is not your strong suit, the calculations involved can still be quite challenging. But have no fear — most trading software packages include one or more versions of the Stochastic Oscillator. So you do not need to remember — or totally comprehend — how to construct a Stochastic Oscillator. You just need to know how to interpret and apply it. So feel free to heave a large sigh of relief now.

The Stochastic Oscillator: Oscillator Values

Ok, then, let’s complete our discussion of the Stochastic Oscillator by going to where the rubber meets the road. I’m now going to explain what the values derived from the Stochastic Oscillator represent. Then we’ll examine some of the ways you can use these values to enhance your trading or investing results.

As I mentioned in Part 1 of this discussion, the Stochastic Oscillator values are plotted in a range from 0 to 100. This range method is used to measure the values on both the %K and %D lines. And all three types of Stochastic Oscillators — Fast, Slow and Full — are plotted on this scale.

So what do these values mean? The numbers derived from the %K and %D lines represent the percentage of time that the closing price a stock or index has been higher than the lowest low in the time period. So for example, a five-day Fast Stochastic Oscillator with a %K line reading of 60 means that the current prices have closed higher than the lowest low three out of the of the past five days — or 60% of the time. A stock or index with a reading below 20 is considered oversold, and a stock or index with a reading above 80 is considered overbought.

There are several methods you can employ when incorporating a Stochastic Oscillator in your trading or investing processes. I’m now going to discuss a few of them. Keep in mind that all of the techniques I’m going to mention can be used with any of the three types of Stochastic Oscillator — Fast, Slow and Full. And these techniques can be used in any time frame. I have used a Stochastic Oscillator on charts with time frames varying from as little as one minute to as great as one month. Just remember that you may discover that different numerical values work better in different time frames — and with different types of Stochastics.

One method that is very popular with traders and investors is to enter a position upon a cross of the %K and %D lines. In other words, when the %K (fast) line crosses above the %D (slow) line, it is considered bullish — and a buy signal.

Conversely, when the %D (slow) line crosses above the %K (fast) line, it is considered bearish — and a sell (or short) signal. Although the MST Trader uses a multiple signal trading approach, one of the signals in our trading system is the one I just described — which we use to determine a stock’s Momentum. And if you employ this particular Stochastic Oscillator signal — I suggest you use it in conjunction with one or more confirming indicators.

Though the cross of the %K and %D lines is probably the most popular Stochastic Oscillator signal, a couple of other techniques can also provide you with superior results. One highly regarded method is to buy — or go long — when either the %K line or %D line falls below 20 (i.e., becomes oversold) and then rises back above 20. The flip side of this technique can be used to sell a stock or call option — or to establish a short position or buy a put option. In that circumstance, you would wait for either the %K or %D line to climb above 80 — i.e., the overbought level — and then fall back below 80.

One other way to employ a Stochastic Oscillator — a variant of the previous method — is to use it to search for divergences from oversold or overbought levels. For example, once either the %K line or %D line falls below 20 — i.e., becomes oversold — note the level where the trough has formed. Then, after either the %K or %D line — whichever one you are using — has moved back above 20, wait for a subsequent turn back down.

If the %K or %D line completes this second downturn by forming a more shallow low, the Stochastic Oscillator is letting you know that the stock or index you are analyzing is gathering bullish Momentum. When whichever line you are following — %K or %D — then turns up from the second (higher) low, you have a positive divergence. This is your entry signal to buy a stock or a call option — or to exit a short position or sell a put option.

This divergence signal works equally well for a short entry, to purchase a put option, or to exit a long position or call option. Wait for the %K line or %D line to rise above 80 — i.e., become overbought — and note the peak value. Then, after the %K line or %D line drops back beneath 80, wait for the line you are monitoring to turn back up. If the %K line or %D line then tops out at a lower level than the previous peak, the Stochastic Oscillator is signaling that Momentum in the stock or index is waning. Once the line you are following subsequently turns down from this second (lower) high, you have a negative divergence — and your new signal.

There are a number of variations on these techniques that you can employ to enhance your bottom line. One minor refinement you can make to the last method is to only act upon long signals when the second move — be it a higher low or a lower high — also achieves an extreme level. In other words, if you are looking to enter a position upon receiving a positive divergence signal, take only those signals where either the %K line or %D line moves below 20 a second time. Then, act when the line you are monitoring crosses back above 20 for the second time.

Again, this technique would be exactly reversed if you were seeking to trade or invest off a negative divergence signal. Wait for the line you are following — %K or %D — to establish a lower peak in overbought territory (i.e., above 80). Then act on the negative divergence signal when either the %K or %D line crosses back below 80 for the second time.

The Stochastic Oscillator: Signals and Price Action

One other method I have found to be very effective when using divergences in the Stochastic Oscillator is to combine the signals from this indicator with the price action of a stock or index. For example, if the Stochastic Oscillator has formed a higher low but the stock or index has made a lower low, you have a divergence between the indicator and the security or market average.

When this circumstance arises, the Stochastic Oscillator reading is telling you that, despite the bearish price action, the stock or index you are analyzing is actually getting stronger. This is so because the percentage of times your stock or index is closing in the upper end of its trading range is increasing. So the Stochastic Oscillator is signaling that, despite the lower price action, the stock or index is gearing up for a potentially significant move in the opposite direction.

Now, when you spot one of these types of divergences — and they are out there — you have located a trading or investing setup with a relatively low-risk entry point. Not only that, but if the trend in the stock or index does, in fact, change, you have entered a position early in the counter move. And by entering the counter move shortly after it has commenced, you have just positioned yourself to capture a significant chunk of that move. So when you can find — and act — on this type of divergence, you limit your risk while expanding your profit opportunity. And isn’t that what trading and investing is all about?

Once again, the same method works equally well on the short side. This time, wait for the Stochastic Oscillator to form a lower peak while the stock or index establishes a higher high. In this instance, the Stochastic Oscillator reading is telling you that the price action is not all that it’s cracked up to be — because, despite the higher prices, Momentum is dissipating. Thus, this divergence between the indicator and the price action offers you a low-risk, high-reward short-side entry.

As I detailed above, the Stochastic Oscillator has a multiplicity of uses. Try the different types of Stochastic Oscillator — Fast, Slow and Full — to see which one gives you the signals that best fit your trading or investing time frame. If you like, experiment with different time periods to find the one(s) that suit your trading or investing style and goals.

I also urge you to try out the different methods I’ve discussed. See what works for you — and which techniques you are comfortable with. You might discover that you can use more than one method in your trading or investing. Whatever you do, I think you will discover that the Stochastic Oscillator deserves a place in your technical toolbox. I know that it has a prominent place in mine.

Trade well…

Mark Bail
November 22, 2005

The Stochastic Oscillator: Technical Tuesday with Mark Bail was originally featured in the Penny Sleuth.

Hello again, Sleuths,

In one of my earlier “Technical Tuesday” columns, I was asked by Head Sleuth Carl Waynberg to analyze the Russell 2000 Growth Index (RUO) and the Russell 2000 Value Index (RUJ) — and share with you my findings. A study of these two indexes was the basis of my Sept. 13 column. However, much has happened since then. So I thought I’d devote today’s column to furnishing you with an update on the current outlook for small-cap issues.

I won’t rehash a lot of the ground I covered in my earlier essay — except where pertinent to where each average stands today. However, if you want more detail on any of the items I touch upon today, please look back at my Sept. 13 column:

http://www.pennysleuth.com/issues/2005/09.13.05.html

I should mention that I undertook this analysis over the weekend of Oct. 22-23. Normally, I would have waited until the close of Monday’s trading session before undertaking this study. However, I am a resident of the great state of Florida.

Now, Florida has many wonderful charms — sunshine, beaches and palm trees among them. But right now, a lady named Wilma has the attention of us Floridians. It is quite possible that my family and I could be without power for some time. So I decided to offer up this study for you without waiting for Monday’s market results.

Now, let’s take a look at what has happened to these two averages since we last checked on them and see where they might be headed in the days and weeks ahead. (All current references are as of the close of trading on Friday, Oct. 21.)  

Russell 2000 Indexes: Russell 2000 Growth Index

When we last checked on the Russell 2000 Growth Index, we observed that this small-cap growth gauge had been in a 4½-month uptrend. At the time, the index had rallied off its late-August low and was gearing up to challenge its 2005 high, set earlier that month. So what’s happened?

Quite simply, the rally petered out. Interestingly, the high for that move occurred on Sept. 12 — at 352.27. Now, there was no way to know for certain that the rally that began in late August was going to fail until earlier this month. But one of the technical indicators I cited back on Sept. 13 did provide some clues.

You will recall that in our prior discussion of the RUO, I noted that the Slow Stochastics Oscillator reading on the RUO had reached 95 — an extreme overbought level. Now, I did not predict that the index was going to fall apart — I typically don’t make predictions. What I try to do is examine an average — together with support and resistance lines, moving averages and other types of indicators — and attempt to get a sense of what is likely to occur going forward.

OK, let’s go back to mid-September’s Slow Stochastics reading. I said in my Sept. 13 column, “Should the RUO Slow Stochastics reading drop below 80, it could signal the beginning of a larger retracement.” As it turned out, that’s exactly what happened. Just two days after notching its Sept. 12 high, the %K (known as the fast line) of the Slow Stochastics dropped below the 80 level — a sell signal. And that sell signal pointed the way to lower prices.

After stalling out a mere 0.46 points below its 2005 high — set on Aug. 2 and 3, the RUO pulled back to 332.45 on Sept. 22, a decline of 5.6%. However, inasmuch as the index was able to hold above 331.90 — its Aug. 29 low –- the earlier uptrend could have been considered intact at that time. At worst, the RUO could have been interpreted as being caught in a trading range — oscillating between the August highs and lows.

Following the successful retest of its August low — the index rallied again –- this time climbing 5.1% to a peak of 349.28 on Oct. 4. In the process, the RUO retook its 50-day moving average. However, once that up leg fizzled, the character of the index changed — dramatically and swiftly.

You see, in just a little over two days, the RUO fell 6.3% — or 22.15 points — to an intraday low of 327.13. The 50-day moving average became a distant memory. But more significant to market technicians — not to mention traders, institutions and large investors — was that the Aug. 29 low was unable to contain the damage.

The significance of the breach of that support level was felt immediately. Just two trading days later — on Oct. 10 — the RUO closed below its 200-day moving average for the first time since May — when the index was in the early stages of its late-spring and early-summer rally. The intervening two weeks has seen the Russell 2000 Growth Index in a death struggle to pull itself back above that key long-term average. So to sum things up, the trend in the RUO has turned decisively lower.

Russell 2000 Indexes: Hindsight Observations

With the acuity provided by 20/20 hindsight, let me offer up a few additional observations. If you look at a daily chart, you will notice that there was a noticeable falloff in bullish Momentum as the index attempted to trade above its Sept. 12 high. As the RUO climbed into the beginning of October, the Slow Stochastics was unable to attain the dizzying overbought heights it reached in September. In fact, the indicator could not even make it back into overbought territory above 80.

So there were several things working against RUO early this month. First, the index was unable to punch through its August peak and register a new yearly high -– or even get above its September top. Second, that latter failure meant that RUO had carved out a series of three lower highs — a very bearish sign.

Then, the fact that Slow Stochastics was unable to move back up into overbought territory on the last rally provided another important clue — suggesting that bullish Momentum in the rally was waning. So the warning signs were there early this month for those who use technical analysis in their trading or investing. Finally, the other technical indicators I mentioned on Sept. 13 –- the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD) -– also provided clues as to the deterioration of the prior bullish Momentum and reversal to a bearish Trend. Both of these indexes were unable to reach their September peaks –- further validating the weakness of the late-September/early-October rally.

 OK, so where do we stand now? Well, it should be clear from what I just detailed above that the present landscape for small-cap growth investors is colored a decided gray. I said back on Sept. 13 that for the (then) bullish Trend to remain intact, any decline in the RUO should be contained by the 50-day moving average, or, failing that, the Aug. 29 low. That clearly did not happen — and that’s bad. As I stated earlier, the RUO fell below its 200-day moving average and established a new low of 316.48 on Oct. 13. That’s a decline of 9.4% from its Oct. 4 high, and 10.3% below its early-August high. Moreover, according to the indicators I use in the MST Trader Alert, the Slow Stochastics Oscillator, the RSI and the MACD –- the recent negative price action is merely symptomatic of underlying weakness in the RUO. As the index put in its Oct. 13 low, all three indicators registered lower readings than they did when the index made a higher bottom, back on Sept. 22. This suggests that the RUO is even weaker than its recent price action suggests. So it will be difficult for the index to gain much traction at this juncture.

All is not lost for small-cap growth bulls, however. Following a large, swift drop -– such as we’ve witnessed over the past few weeks — it would not be surprising to see RUO attempt a rally. That may, in fact, be taking place right now. The index has been able to move back above its 200-day moving average — at least for the moment anyway. Should the index stabilize here and regain some equilibrium, a tradable rally could be in the offing.

If RUO can remain above its 200-day moving average — and, more importantly, stay clear of its Oct. 13 low — the path would be clear for a move up to 332 — the area of both the August and September lows. The next level to watch — if the index clears 332 — would be a challenge of the 50-day moving average — currently at 337.46. That may not sound like much — but it’s 3.5% from Friday’s close of 326.05. In this market environment, that’s nothing to sneeze at.

However, without a large, sustained pickup in buying volume, any rally would likely be short-lived. In any event, it is imperative that the Oct. 13 low of 316.48 holds. Should RUO close below that level, we could easily see much lower prices.

Russell 2000 Indexes: Russell 2000 Value Index

The daily chart of the Russell 2000 Value Index looks very similar to its growth counterpart. Back when we last examined this index, it was at the tail end of a strong uptrend that had been in force since late April.  

The rally off the late-August low in the RUJ topped out on Sept. 12 at 1,010.01 — 1.6% below its early-August high. Now, although the index appeared poised to test its 2005 high, one of the technical indicators tipped us off to a potential problem — the same one that showed up on the RUO landscape. Here’s how I described that possible area of concern back on Sept. 13:

“However, there is one caution flag out there. Again, as with RUO — the Slow Stochastics Oscillator on RUJ has moved well into overbought territory — above 90. Therefore, I would not be surprised to see a pullback. Should that indicator slide below the 80 level, a decline back to either of the short-term support areas referenced above could be in the offing.”

Well, that is just how events unfolded. The Slow Stochastics moved from its extreme overbought level back below 80 — a bearish signal. That was the tipoff that prices in the RUJ were set to weaken. And weakness we saw as the index fell 5.5% — making an intraday low on Sept. 22 at 954.73. That low was right in the area of — actually slightly below — the 958.55 low registered on Aug. 29.

Now, I don’t point that out to demonstrate what a great market seer I am. As I said earlier, I don’t normally try to make predictions on future market action. However, as a devoted market technician, I use technical analysis to alert me to the scenarios that are most likely to unfold. Again, I did not call the downdraft in RUJ. However, I did point out the price area where the index could decline. And I was able to alert you to that possibility because of a technical indicator. But that’s why we have a “Technical Tuesday” column, right?

Let’s get back to the RUJ. Just like the RUO, the small-cap value index rallied back to a failed lower high on Oct. 4 — at 993.93 — before crashing and burning over the next two weeks and notching a new low at 912.08 on Oct. 13. So the RUJ also made three successive lower highs. And like the RUO, this index also saw all three indicators referenced above — the Slow Stochastics Oscillator, the RSI and the MACD — form both lower peaks and lower lows in October than in September. So here too the technical condition remains weak.

OK, so is the current outlook for the Russell 2000 Value Index as negative as the one for the Growth Index? Actually, it’s worse. Remember, I said that the RUO — if it can hold above its 200-day moving average — could actually be in the early stages of a tradable rally. The RUJ, however, has found reclaiming its 200-day benchmark a bit daunting. In fact, the 200-day moving average has stuffed all rally attempts in the index over the last three trading sessions. So it goes without saying that for the RUJ to have any hope of scoring profits in the near term, an immediate move above its 200-day line is essential.

Should the RUJ recapture its 200-day average, the next price level to watch would be the area of the August and September lows, between 954 and 958. That level could prove difficult to penetrate. However, if the index is able to get through that resistance area, the RUJ could trade up to the 50-day moving average — which currently resides at 970.36. But given the significant recent weakness in the index, a move of that magnitude may be a tall order. And for the RUJ to have any chance of undertaking any sort of rally at this time, the index must hold above its Oct. 13 low.

The bottom line is that both the RUO and the RUJ appear technically weak at the present time. It is possible — even likely — that both indexes put in near-term lows on Oct. 13. However, barring a sudden demonstration of bullish enthusiasm — manifested by high-volume positive trading sessions — any rally in either index should be muted.

Even muted rallies can provide opportunities to nail down quick trading profits. So small-cap issues may offer a chance to make some money on the long side. That’s especially true of growth companies, which look stronger than value stocks in the current environment. But don’t expect either the RUO or the RUJ to challenge their 2005 highs just yet. Unless there is a renewal of the buying enthusiasm we saw in the spring, the odds are good that the recent lows will be tested — if not breached — before any meaningful rally can take flight.

I hope you found this analysis helpful and thought provoking. And I hope it has further piqued your interest in learning more about technical analysis. Meanwhile, I’ll be readying my next Technical Tuesday column for you — when we’ll go back to examining the ins and outs of another indicator.

Trade well,

Mark Bail
October 25, 2005

Russell 2000 Indexes: Technical Tuesday with Mark Bail was originally featured in the Penny Sleuth.