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Overbought or Oversold? How Stochastics Can Help Time Trades

January 3, 2013

Ever had an apple fall on your head while sitting under an apple tree? No? Me either. But Sir Isaac Newton did, and with that small thud, the Universal Law of Gravitation was born. “What goes up must come down” is true not only of apples, it’s true of stocks. And there are several chart oscillators that try to identify share price turning points that investors might exploit.

One of mostly regularly followed trend indicators is the Stochastics Oscillator. It measures the distance between a stock’s closing price and the range of highs and lows over a specified period. As the stock closes nearer the high of the range, the Stochastic Oscillator rises, and as the stock closes nearer the low of the range, it falls. Proponents tend to like the Stochastic Oscillator because of its easy-to-remember defined range of 0-100, its support and resistance indications, and its ability to signal divergences in share movement. According to its developer, Dr. George Lane, the Stochastic Oscillator moves into overbought and oversold areas above 80 or below 20, respectively.

As with most oscillators, you’ll first need to know the directional trend of the stock: rising or falling. And you’ll need to determine that trend over a set time, for example, a 20-period simple moving average (SMA). It may help to look at your stock in a table, like below, to see a stock’s direction, position, and relationship to the SMA.

Rising Above >80 Bullish
Rising Above 20 Bullish
Rising Above <20 Neutral
Falling Below >80 Neutral
Falling Below 20 > STO > 80 Bearish
Falling Below <20 Bearish

FIGURE 1: Stochastic Oscillator developer Dr. George Lane says the indicator moves into overbought and oversold areas above 80 or below 20, respectively. For illustrative purposes only. Past performance does not guarantee future results.

Let’s focus on one of the three variations of this indicator, known as the Slow Stochastic. In Figure 2, you’ll notice two lines. The fast moving line is shown as %K (in black) and the slow moving line is %D (in red). A Slow Stochastic smoothes the %K line using a default three-period simple moving average (SMA). The %D, then, reflects a moving average of %K. The %K crossed above the %D, giving an indication of support. As for the price portion of the chart, a move above the 20-day SMA shows a potential bullish entry signal. Conversely, a potential exit presents itself when the stock closes below the 20-day SMA.

Whether apples or stocks, gravity pulls them toward the earth or back to their averages. Sir Isaac found his big moment by happy accident. But charting with tools including Stochastics can mean you won’t have to wait for the apple to drop, but can try to pinpoint when it might wiggle loose.

Dow Jones Industrial Average

FIGURE 2: The Dow Jones Industrial Average is tracked using a 14-period look-back and a five-period smoothing of the %D. On December 20, the %K (black) crossed above the %D (red), giving an indication of support. A quick check of the 20-day SMA shows the stock trading above this line and thus, a bullish entry signal. Conversely, a potential exit presented itself when the stock closed below the 20-day line on March 6, 2012.

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