Mark Bail differentiates among the three types of Stochastic Oscillator, and explains how to use it to improve your trading or investing results.

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

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