Stochastics Oscillator: %D Line, Formula

STOCHASTICS (K%D)

The Stochastic oscillator was popularized by George Lane (presi­dent of Investment Educators, Inc., Watseka, IL). It is based on the observation that as prices increase, closing prices tend to be clos­er to the upper end of the price range. Conversely, in downtrends, the closing price tends to be near the lower end of the range. Two lines are used in the Stochastic Process—the %K line and the %D line. The %D line is the more important and is the one that pro­vides the major signals.

The intent is to determine where the most recent closing price is in relation to the price range for a chosen time period. Fourteen is the most common period used for this oscillator. To determine the K line, which is the more sensitive of the two, the formula is:

%K = 100 [(C - L14) / (H14 - L14)]

where C is the latest close, L14 is the lowest low for the last 14 periods, and H14 is the highest high for the same 14 periods (14 periods can refer to days, weeks, or months).

The formula simply measures, on a percentage basis of 0 to 100, where the closing price is in relation to the total price range for a selected time period. A very high reading (over 80) would put the closing price near the top of the range, while a low reading (under 20) near the bottom of the range.

The second line (%D) is a 3 period moving average of the %K line. This formula produces a version called fast stochastics. By taking another 3 period average of %D, a smoother version called slow stochastics is computed. Most traders use the slow sto­chastics because of its more reliable signals.[1]

These formulas produce two lines that oscillate between a vertical scale from 0 to 100. The K line is a faster line, while the D line is a slower line. The major signal to watch for is a divergence between the D line and the price of the underlying market when the D line is in an overbought or oversold area. The upper and lower extremes are the 80 and 20 values. (See Figure 10.15.)

A bearish divergence occurs when the D line is over 80 and forms two declining peaks while prices continue to move higher. A bullish divergence is present when the D line is under 20 and forms two rising bottoms while prices continue to move lower. Assuming all of these factors are in place, the actual buy or sell sig­nal is triggered when the faster K line crosses the slower D line.

There are other refinements in the use of Stochastics, but this explanation covers the more essential points. Despite the high­er level of sophistication, the basic oscillator interpretation remains the same. An alert or set-up is present when the %D line is in an extreme area and diverging from the price action. The actual signal takes place when the D line is crossed by the faster K line.

The Stochastic oscillator can be used on weekly and month­ly charts for longer range perspective. It can also be used effective­ly on intraday charts for shorter term trading. (See Figure 10.16.)

One way to combine daily and weekly stochastics is to use weekly signals to determine market direction and daily signals for timing. It's also a good idea to combine stochastics with RSI. (See Figure 10.17.)

Figure 10.15 The down arrows show two sell signals which occur when the faster %K line crosses below the slower %D line from above the 80 level. The %K line crossing above the %D line below 20 is a buy signal (up arrow).

Figure 10.16 Turns in the 14 week stochastics from above 80 and below 20 did a nice job of anticipating major turns in the Treasury Bond market. Stochastics charts can be constructed for 14 days, 14 weeks, or 14 months.

Figure 10.17 A comparison of the 14 week RSI and stochastics. The RSI line is less volatile and reaches extremes less frequently than stochastics. The best signals occur when both oscillators are in overbought or oversold territory.

LARRY WILLIAMS %R

Larry Williams %R is based on a similar concept of measuring the latest close in relation to its price range over a given number of days. Today's close is subtracted from the price high of the range for a given number of days and that difference is divided by the total range for the same period. The concepts already discussed for oscillator interpretation are applied to %R as well, with the main factors being the presence of divergences in overbought or over­sold areas. (See Figure 10.18.) Since %R is subtracted from the high, it looks like an upside down stochastics. To correct that, charting packages plot an inverted version of %R.

Figure 10.18 Larry Williams %R oscillator is used in the same fashion as other oscillators. Readings over 80 or under 20 identify market extremes.

Choice of Time Period Tied to Cycles

Oscillator lengths can be tied to underlying market cycles. A time period of }/2 the cycle length is used. Popular time inputs are 5,10, and 20 days based on calendar day periods of 14, 28, and 56 days. Wilder's RSI uses 14 days, which is half of 28. In the previous chapter, we discussed some reasons why the numbers 5, 10, and 20 keep cropping up in moving average and oscillator formula­tions, so we won't repeat them here. Suffice it to mention here that 28 calendar days (20 trading days) represent an important dominant monthly trading cycle and that the other numbers are related harmonically to that monthly cycle. The popularity of the 10 day momentum and the 14 day RSI lengths are based largely on the 28 day trading cycle and measure */2 of the value of that dominant trading cycle. We'll come back to the importance of cycles in Chapter 14.

THE IMPORTANCE OF TREND

In this chapter, we've discussed the use of the oscillator in market analysis to help determine near term overbought and oversold conditions, and to alert traders to possible divergences. We start­ed with the momentum line. We discussed another way to mea­sure rates of change (ROC) by using price ratios instead of differ­ences. We then showed how two moving averages could be com­pared to spot short term extremes and crossovers. Finally, we looked at RSI and Stochastics and considered how oscillators should be synchronized with cycles.

Divergence analysis provides us with the oscillator's greatest value. However, the reader is cautioned against placing too much importance on divergence analysis to the point where basic trend analysis is either ignored or overlooked. Most oscillator buy signals work best in uptrends and oscillator sell signals are most profitable in downtrends. The place to start your market analysis is always by determining the general trend of the market. If the trend is up, then a buying strategy is called for. Oscillators can then be used to help time market entry. Buy when the market is oversold in an uptrend. Sell short when the market is overbought in a downtrend. Or, buy when the momentum oscillator crosses back above the zero line when the major trend is bullish and sell a crossing under the zero line in a bear market.

The importance of trading in the direction of the major trend cannot be overstated. The danger in placing too much impor­tance on oscillators by themselves is the temptation to use diver­gence as an excuse to initiate trades contrary to the general trend. This action generally proves a costly and painful exercise. The oscil­lator, as useful as it is, is just one tool among many others and must always be used as an aid, not a substitute, for basic trend analysis.

WHEN OSCILLATORS ARE MOST USEFUL

There are times when oscillators are more useful than at others. During choppy market periods, as prices move sideways for several weeks or months, oscillators track the price movement very close­ly. The peaks and troughs on the price chart coincide almost exact­ly with the peaks and troughs on the oscillator. Because both price and oscillator are moving sideways, they look very much alike. At some point, however, a price breakout occurs and a new uptrend or downtrend begins. By its very nature, the oscillator is already in an extreme position just as the breakout is taking place. If the break­out is to the upside, the oscillator is already overbought. An over­sold reading usually accompanies a downside breakout. The trader is faced with a dilemma. Should he or she buy the bullish breakout in the face of an overbought oscillator reading? Should the down­side breakout be sold into an oversold market?

In such cases, the oscillator is best ignored for the time being and the position taken. The reason for this is that in the early stages of a new trend, following an important breakout, oscillators often reach extremes very quickly and stay there for awhile. Basic trend analysis should be the main consideration at such times, with oscillators given a lesser role. Later on, as the trend begins to mature, the oscillator should be given greater weight. (We'll see in Chapter 13, that the fifth and final wave in Elliott Wave analysis is often confirmed by bearish oscillator divergences.) Many dynamic bull moves have been missed by traders who saw the major trend signal, but decided to wait for their oscillators to move into an oversold condition before buy­ing. To summarize, give less attention to the oscillator in the early stages of an important move, but pay close attention to its signals as the move reaches maturity.