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Stochastic Models/Stochastic Oscillator

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#1 Guru Dudette

Guru Dudette

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Posted 31 January 2007 - 11:19 AM

Stochastic Models/Stochastic Oscillator

The Stochastic Oscillator is a measure of the relative momentum of current prices to previous closing prices within a given interval. When it is plotted, it is two lines that move within a range of 0 and 100. Values above 80 are considered to be in overbought territory giving an indication that a reversal in price is possible. Values below 20 are considered oversold and again are an indication that a reversal of the price trend is a higher risk. In a strong trending environment, the Stochastic Oscillator can stay in overbought or oversold territory for some time while price continues in a single direction.

In relation to a longer term price trend environment, the stochastic provides little interest. In its construction it is meant to relate the current periods momentum to the most recent previous periods of momentum in price in an attempt to identify periods where momentum may be easing or increasing. The easing (at a top) or increase (at a bottom) of momentum occurs at reversal points for the price trend being measured. However changing momentum also occurs during times when there is no change in the overall trend in prices and should be understood as a period when a reversal in price trend is possible but not guaranteed.

A shorter period Stochastic represents the trend development for a shorter period of time. Not always is a change in the price momentum also a change in the price trend of a stock. For any technical indications of potential future price trend development, it is important to build a wide body of evidence when developing an expectation for future prices. At a reading of zero, the Stochastic Oscillator implies that the securities close is at the lowest price that it has traded during the preceding x periods (x being defined as the number of periods in the calculation).

At a reading of 100, the Stochastic Oscillator implies the securities close is at the highest price it has traded during the period of the calculation. The basis for interpreting the stochastic is the assumption that prices tend to close near the upper part of a trading range during an up trend and near the lower part during a downtrend. In addition, extreme periods are often followed by a reversal of price trend and so are called "over-bought" and "over-sold" area's. Not always will a reversal follow periods when the Stochastic is in over-bought or over-sold area's, however the presence in over-bought and over-sold alerts a trader to look for further evidence that a price trend reversal may be near.

Other interpretive qualities of the Stochastic Oscillator is the search for divergences between the oscillator and price. A divergence of peaks is often followed by a drop in price. A divergence of troughs often precedes a rise in price. Notice that divergences can go against the larger price trend suggesting caution and lower price projections as each new segment of price trend emerges. Divergences also can continue for extended periods before any evidence of price trend reversal occurs. A divergence that occurs over a shorter period of time would suggest a shorter term outlook on the reaction in prices. A divergence that continues over a longer period of time would represent a larger pool of activity and would be expected to result in longer and larger period of new price trend should a reversal in price trend result after a long period of divergence between and indicator and price.

The Stochastic is made up of two lines, the dotted line is called the %D which is a moving average of the %K which is a calculation of the securities highest high minus the lowest low as the denominator and the close of the current period minus the lowest low computed as a ratio, converted to decimals and multiplied by 100.

A buy signal is given when the oscillator falls below 20 and then rises above 20, indicating a return of interest in the stock. This type of interpretation requires other supporting evidence to avoid whipsaws or failed signals. A sell signal is given when the oscillator rises above 80 and then falls below 80. The signal is the re-entry into the mid-zone for the indicator after being in over-bought or oversold territory. This interpretation works poorly in a strong trending environment. Traders also look for crossovers of the fast stochastic (solid red) and the smoothed (dotted lines) looking for confirming evidence of a signal to buy or sell.

"I'd rather be vaguely right than precisely wrong." J.M.Keynes