John Person’s view on Stochastics

Due to the substantial growth in international economies, we are witnessing huge increases in volatility and wider than normal daily ranges in most markets as a result of this booming growth. Most countries, from a financial perspective, are now interdependent of each other and this in effect has created an increase in the demand for raw commodities as well as opened the door for new technologies and business opportunities. At times, this demand it has caused strains on the financial community and that has raised demand from speculators trying to capitalize on these massive price fluctuations. Traders from commercials tying to hedge risks to large Hedge funds and small speculators are seeking to profit from these tremendous market moves. As we all know, when there is an opportunity to profit comes risk of loss. Unfortunately many novice speculators have a tendency to be right in calling market moves but have poor timing on entering or exiting the market as prices cycle between highs and lows. The goal of this article is to familiarize you with a technical oscillator tool known as Stochastics. This tool can be instrumental in helping all traders in volatile market conditions filter out between cycle high price points, known as peaks and cycle low points referred to as troughs or corrections. Stochastics is a range based oscillator it is also considered a momentum oscillator. George C. Lane is credited with creating the formula. I had the privilege of working for George back in 1980. His indicator is a popular technical tool used to help determine whether a market is overbought, meaning prices have advanced too far too soon and due for a downside correction, or oversold, meaning prices have declined too far too soon and due for an upside correction. It is based on a mathematical formula that is computed to compare the settlement price of a specific time period to the price range of a specific number of past periods or look back period. The method works based on the premise that in a bull or up trending market, prices will tend to make higher highs and the settlement price, or close, will usually tend to be in the upper end of that time periods trading range, or at least closer to the highs of that “look back” period. When the momentum starts to fade, settlement prices will start to push away from the upper boundaries of the range and the Stochastics Indicator will show that the bullish momentum is starting to change. The exact opposite is true for Bearish or down trending markets. There is Fast Stochastic’s and Slow Stochastics. The difference is how the parameters are set to measure the change in price based on specific time periods. A higher rate of sensitivity will require the number of periods in the calculation to be decreased. This is referred to as a gauge in sensitivity. It enables one to generate faster and a higher frequency of trading signals in a short time period. This is what “fast” Stochastics does and the settings I use are described in this article. There are two lines that are referred to as %K and %D. These are plotted on a horizontal axis for a given time period and the vertical axis is plotted on a scale from 0% to 100%. As you will see from the formula below, %K will be the faster of the two lines and will change direction because the %D line is a moving average of %K.

The formula to calculate the first component, %K: (14 period)

The value of %K =c-Ln/Hn-Ln*100

c=closing price of current period, Ln= lowest low during n-period of time, Hn=highest high during n-period of time and n=number of periods.

The second calculation is the %D (3 period) It is the moving average of %K

It is calculated by: %D=100(Hn/Ln)

HN= the n-period sum of (c-Ln).

The unique feature of the Stochastics reading is it has two functions, a moving average crossover feature and the range based oscillator feature with readings between 0 percent and 100 percent. The main guidelines reflect that readings over 80% indicate a market condition is near overbought and ripe for a downside correction. It helps indicate that a bullish or up trending cycle is nearing completion and that a pause or correction in prices is due. Readings under 20% signals the market is oversold and ripe for a bounce, it shows a bearish cycle or down trend is nearing exhaustion and a pause or reversal rally is to be expected. Traders can manipulate or “tweak” these settings for different markets and when markets are in various volatility conditions. Stochastics is a great indicator to identify turning points; however, I look for more clues within the indicator as well as other confirming criteria’s to trigger an entry into trade. When using Stochastics I look at the indicator to corroborate the timing of a trade or a market turn associated with a change in price action. As stated, this indicator measures the strength or weakness of the market by the current close of the market as it is weighted against an established range of a specific number of past time periods. In a bullish market condition we generally see prices close towards the upper end of the range and closer to the highs. But after a prolonged period of time and price advance, when markets are making their respected highs once we see prices starting to close towards their lows, this is a sign that the bullish trend is exhausting itself. Therefore, when using the fast stochastics settings I look for these conditions to be met to identify a bearish reversal:

When the readings are above 80%, and %K crosses below the %D line and both lines close back down below the 80% line, then a “hook” sell signal is generated.

Examine the chart on Apple Inc, (AAPL) in figure “A”. This was right before earnings were released. Notice at the peak in prices, the corresponding point in the stochastics readings warned that the market was in danger of a correction or at the very least a pause.

Despite the expectations for this stock to do well from enormous holiday sales of IPOD’s, the Stochastics readings warned that the market was in danger of a correction. As the large gap shows on the charts, many investors sold on the news. The Stochastics indicator showed the %K line crossed below the %D line when both values were above the 80% level and once both lines closed back down below the 80% line, then a “hook” sell signal kicked in. Subsequently prices continued lower. Here is a great example where a technical indicator may have spared you a loss from buying before an earnings report as the technical conditions were not right for such a set-up.

In figure B we also see stochastics warned that the market is concluding its bullish trend or cycle high as prices reach near 12575. That would present a potential profitable scalp of 40 points at 5 dollars per point per contract which is $200 dollars on a day trading margin of $500 dollars that most Futures brokerage firms charge, or a 40% return. Let’s apply these concepts to a different market in a different time frame. Figure C shows a weekly chart on Urban Outfitters (URBN). Notice that this stock was in deep sea dive mode plunging from 32.00 down to just under 14.00 per share. But notice the stochastics indicator as %K and %D finally crossed and closed back above the 20% line. A bottom was confirmed as we had strong volume that spiked on the reversal up days.