Understanding the Stochastic Indicator

[Justin]

Provided by Clearstation

Making a decision about what kind of position to take on a stock is much like cooking a roast. For the roast to be cooked perfectly, all the conditions have to be just right. A pan that it will fit in, a hot oven, a timer so you don't overcook--they all work together to produce a succulent meal. If the oven is too hot or the timer isn't set properly, you might be stuck with a hunk of charred meat. Stocks work the same way. All the conditions, or indicators, need to be used in sync for the best results. When you use the indicators in conjunction with each other, the chances that you'll make a more profitable decision increase. If MACD is the hot oven, then stochastic is the timer. Stochastic follows the short-term movements of the stock and gives you an idea of when to take action. Stochastic is shown by two lines (red and blue) fluctuating between 0 and 100. At the 20 and 80 marks, there are horizontal black lines. When the red and blue lines dip together under the 20 line, it means the stock is oversold (everyone is selling). When the lines float together above the 80 mark, the stock is overbought (everyone is buying). So what does it all mean? Provided the other indicators are healthy, you want to buy when a stock is oversold because the short-term prices are likely to rise. Sell when a stock is overbought, and short-term prices are likely to fall!
How is stochastic handy? In late June, do you see how stochastic was indicating that the stock was oversold? Both the red and blue line are below the 20 mark. The stock had been in an oversold state for sometime. At some point it was going to turn around, which shortly thereafter it did. In the beginning of September, the stock rose for the third time into an overbought state. By following this signal, you would have got out with a profit. A word of caution: stochastic is an indicator of short-term activity! It shows you when a stock's price is oscillating (moving up and down in a range) rather than trending (moving in one direction continuously). Be careful not to base long-term actions on it.

[AlexG]

use slow stoch


Stochastic Oscillator
What does it Mean? A technical momentum indicator that compares a security's closing price to its price range over a given time period. The oscillator's sensitivity to market movements can be reduced by adjusting the time period or by taking a moving average of the result. This indicator is calculated with the following formula:

%K = 100[(C - L14)/(H14 - L14)]
C = the most recent closing price
L14 = the low of the 14 previous trading sessions
H14 = the highest price traded during the same 14-day period.

%D = 3-period moving average of %K


Investopedia Says... The theory behind this indicator is that in an upward-trending market, prices tend to close near their high, and during a downward-trending market, prices tend to close near their low. Transaction signals occur when the %K crosses through a three-period moving average called the "%D".

http://www.investopedia.com/terms/s/...oscillator.asp

[hammack58]

boy was that helpful. thanks

[Neocat]

I was confused too, so I wrote this for myself to learn it.

The Three Tools

When all three tools say “buy” then it is time to buy. When all three tools say “sell” then it is time to sell.

The MACD is the combination of two moving averages – a fast one and a slow one - and how they interact (converge and diverge). It shows when momentum pressure is getting stronger either upward or downward. If most of the money is institutional, then it shows when they are getting in or out.

A 12-26-9 MACD is two lines. The first line is the difference between the 12 and 26 day moving averages. The second line is the 9 day moving average. The first number is actually the MACD, then the MACD is plotted with the 9 day EMA. The crossing of the lines is the trigger point. When the MACD crosses above the 9 day EMA, the stock is likely to go up in price. When it crosses below, it is likely to go down in price.

One revision is 8-17-9 MACD. This is more responsive when looking for stocks that are going to move up rapidly in price.

The significance of a positive trigger is that the big guys have been putting enough money into the stock long enough that a significant price change is likely.


Stochastics is a momentum tool that tracks overbuying and overselling. Overselling means too much supply, so price goes down. When the buy line has a positive crossing, this means that the stock is going from oversold (too many sellers, too much supply) to overbought (lots of buyers, not enough supply). This is when it is time to buy.

The stochastic looks at the high and low price over some period (usually 14 days). The stochastic number is where today’s price fits as a percentile of these prices. 57 would mean today’s price is at the 57th percentile of all the prices looked at.

When the stochastic moves down below the 20th percentile, the stock is getting oversold (too many sellers). When it moves up through the 20th percentile, it shows that the big guys are starting to buy. When it moves up through the 80th percentile, the stock is overbought (lots of buyers, not enough sellers). When it moves down through the 80th percentile, the big guys are cashing out and the price is likely to drop.

Stochastics is plotted against a 5 day EMA to provide the trigger points. The trigger is the crossing.

The first number covers the number of periods (usually 14 trading days). The second number is the trigger EMA (usually 5). Some sites use 5-5, but this makes too many triggers, so we use 14-5. On the left of the chart is the percentages. When the stochastic crosses up through the 20th percentile, that is a positive signal. When it crosses down through the 80th percentile, that is a negative signal. These signals are usually preceded by a crossing with the EMA, so the crossing is an early warning.


The moving average is a psychological barrier to the price. It makes a floor or ceiling. As the price moves above the moving average, then it is breaking through the psychological ceiling and that signals that the attitude toward this stock has become positive. A 10 day MA will give an early signal to buy. A slower MA (like 50) will make it the last buy signal.

[Justin]

Excellent post 8)

[klund]

Originally Posted by Justin

Excellent post 8)

What, just because he has taken a complicated subject matter and explained it in an easy to understand way, he gets an "Excellent post" compliment?

Oh, maybe you're right.

Great post!

Kevin

[AlexG]

hey neo its actually when 1 of the tools tells u to sell is when u sell, u will find out that one signal will tell u to get out before the other 2 join red thus saving u money

[klund]

Originally Posted by AlexG

hey neo its actually when 1 of the tools tells u to sell is when u sell, u will find out that one signal will tell u to get out before the other 2 join red thus saving u money

Actually, I think Phil says that you buy on three greens, and sell on 2 reds.

Kevin

[Neocat]

Actually, Neocat is a she.

I think Phil might mention getting out on one or two sell signals somewhere else (which I would do if my money were on the line), but on page 209, he says:

"When all three Tools are saying "buy", it's time to get in. When all three are saying "sell," it's time to get out. (Yes, wait for all three to give the signal.)"

[AlexG]

your suppose to be in a stock when all 3 signals are green right? so how is it possible to be in a stock when 2 signals are green and one signal is red :shock: