# Id'Ing When To Buy And Sell Using The Stochastic Oscillator

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TECHNICAL ANALYSISFIGURE 1. SLOW VS. FAST STOCHASTIC OSCILLATORS FOR GLOBAL MARINEFast Stochastic OscillatorSlow Stochastic OscillatorOpen, High, Low and Closing Prices FAST VS. SLOW STOCHASTICSThe formula we provided on page24 to calculate points on the %Kline leads us to a stochastic oscillator that is extremely volatile and,therefore, is often referred to as a“fast” stochastic. Lane realized thatdue to the fast stochastic’s volatility,it was not very useful as a tradingtool because it generated frequentand often inaccurate trading signals.In an attempt to create an indicatorthat was less volatile and, therefore,more useful, Lane created a “slow”stochastic by: Making the original %D line thenew %K line—the stochastic is“smoothed” or slowed by averagingover three points. In other words,the new %K line is a three-pointmoving average of the fast %Kline; and Using a three-point moving averageof the original %D line as the slowstochastic’s %D line. Therefore, weare taking the original %K line,smoothing or averaging it overthree points, and then averagingthis line over three points oncemore.Figure 1 illustrates both the fast(upper window) and slow (middlewindow) stochastics for GlobalMarine. In both instances, the %Kline is the solid line, and the %Dline is the dotted line. In bothstochastic windows, the two horizontal lines mark the overbought(indicator value above 80) andoversold areas (indicator valuebelow 20) as defined by Lane. As wewill see later, the movements of the%K and %D lines above and belowthese levels are useful when timingyour buy and sell decisions.The numbers in parentheses on thechart indicate the number of pointsused in calculating the movingaverages period used. Looking at theslow stochastic in the middle window, you see (5,3) after the %Klabel. This indicates that the pointson the %K line are calculated overfive points and then “smoothed,” oraveraged, over three points. The%D lines in Figure 1 are a threepoint moving averages of theirrespective %K lines.When comparing the slow and faststochastics, you can immediately seethat the slow stochastic is morerounded and less volatile than thefast stochastic. Note, also, that thereare times when the fast stochasticlines either cross above 80 or below20, while the slow stochastic linesdo not. By slowing the lines, theslow stochastic generates fewertrading signals.INTERPRETATIONYou can see in the figures that thestochastic oscillator fluctuatesbetween zero and 100. A stochasticvalue of 50 indicates that the closingprice is at the midpoint of theAAII Journal/October 200025

TECHNICAL ANALYSISFIGURE 2. A BEARISH DIVERGENCE FOR PHOTON DYNAMICSStochastic OscillatorOpen, High, Low, and Closing Prices stochastic, reversed course,and fell from a high of 85to a low near 45 in lessthan a month.Bullish divergences occurwhen the price is makingnew lows while the oscillatoris making new highs—orfailing to make new lows—below the 20 line. Here youcan expect prices to bottomout and begin to rise, matching the behavior of theindicator. OVERBOUGHT &OVERSOLD trading range for the specifiedperiod. As values reach above 50, itindicates that the price is moving upinto the higher trading-range for theperiod. The opposite is true whenvalues fall below 50—the price ismoving into the lower levels of thetrading range for the period.At the extreme, a value of 100signals that the price closed at theabsolute highest point for the period,while a value of zero means that theprice closed at the lowest point forthe period.The three most common ways touse the stochastic oscillator aredivergences, crossovers, and oversold/overbought.DIVERGENCESWhen Lane first introducedstochastics, he believed that the onlyvalid signal occurred when adivergence developed between theprice and the stochastic oscillator,more specifically the %D line.Divergences between price and anindicator occur when the behaviorin the price is not mirrored by the26AAII Journal/October 2000indicator.A bearish divergence, for example,takes place when the prices aremaking higher highs while thestochastic is making new lows(preferably below 20), or is failingto also make new highs. This occursbecause, while prices are reachingnew intraperiod highs, the closingprices are falling. When you seethis, you can reasonably expect theprice to fall in line with the indicator—which means prices will reversecourse and begin to fall.Figure 2 provides an example of abearish divergence between the dailyprice of Photon Dynamics and fiveday stochastics (with three-dayslowing). As you can see, pricesmoved in a generally upwarddirection (higher highs and higherlows) from late June through themiddle of July—creating threesuccessive peaks, each higher thanthe previous. At the same time,however, the stochastic oscillatorwas moving in the opposite direction, creating two successively lowerpeaks—both of which are above 80.Eventually, prices followed theThe horizontal lines at 20and 80 mark overbought andoversold areas for a givensecurity. A security is considered overbought when thestochastic lines rise above 80as closing prices nearintraperiod highs. Likewise,it is viewed as oversold whenthey cross below 20 indicatingclosing prices are near the intraperiod low. These levels representpoints where one would expectprices to reverse—the extreme pricelevels are not sustainable over time.Note that either line—the %K lineor %D—may be used, althoughmost technicians consider the %Dline to be more accurate.There are several strategies thatcan be used based on overboughtand oversold levels.The strictest rule would be to sellwhen the %D line crosses above80—in other words, when the stockbecomes overbought—and buy whenit crosses below 20 and becomesoversold. This strategy, however,has flaws. To begin with, there is noindication as to how long thesecurity will remain at the priceextremes, meaning that the securitycould become even more overboughtor oversold. Therefore, if you soldwhen the %D line crossed above 80,you run the risk of missing furtherprice gains, just as you run the riskof buying prematurely before the

are times when the fast stochastic lines either cross above 80 or below 20, while the slow stochastic lines do not. By slowing the lines, the slow stochastic generates fewer trading signals. INTERPRETATION You can see in the figures that the stochastic oscillator fluctuates between zero and 100. A stochastic value of 50 indicates that the closing

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