Stochastics (Fast Stochastics)
Indicator Type: Counter Trend
Introduction:
The Stochastic Process was invented by Dr. George C. Lane many years ago under
this basic premise:
During periods of decrease daily closes tend to accumulate near the extreme low
of the day and conversely during periods of increase daily closes tend to
accumulate near the extreme highs of the day.
This indicator is designed to show conditions of overbought and oversold.
Stochastics are divided into two types regular Stochastics, often referred to as
Fast Stochastics, and Slow Stochastics. Fast Stochastics are said to be more
sensitive to price changes and can give very greatly in the short-term, hence
the need for Slow Stochastics.
Interpretation:
Stochastics display two lines that move in a vertical scale between 0 and 100 –
representing percentiles from 0% to 100%. Think of the level of Stochastics as
where the most current close is within a specific range. For example, if
Stochastics are reading 50%, the current close is in the middle of the price
range for specified period of time. If Stochastics are reading 100%, the close
is at the high of the current, and 0% represents prices being at the low. Of
course, because Stochastics are smoothed this is not exactly true, but should
help you visualize the information being shown. This will also help you to
understand why Stochastics are a counter trend indicator, in that the underlying
principle behind Stochastics is that prices will move back to the center of the
trading range, or the opposite extreme.
When both lines move to an area below 20 on this scale they are said to be in an
oversold zone. Conversely, when both %K and %D move to above 80 on this same
scale they are indicating overbought. It is this indication of market sentiment
that makes this counter trend indicator useful.
George Lane emphasized that the most important signal generated by this method
was the difference or divergence between %D and the underlying market price. He
said that the divergence is where %D line makes a group of lower highs while the
market makes a series of higher highs. This would indicate an overbought
condition. The reverse would be true of an oversold market, with %D making
higher lows and prices making lower lows.
Trade triggers to buy are created when, during an oversold condition
(Stochastics below 20) the slow line, %D is crossed by the faster moving line,
%K.
The opposite would occur with a sell signal. The faster %K line crosses above
the slower %D line, when both are at a reading above 80.
As with a dual moving average system when the faster reacting indicator crosses
the slower moving indicator a buy or sell is signaled. Because Stochastics give
an indication of either overbought or oversold you would first want to see both
lines in that above 80 or below 20 range and sloping out of that range back to
the middle before looking for these trade triggers.
Stochastics (Slow Stochastics)
Indicator Type: Counter Trend
Introduction:
The slower version of Stochastics is commonly believed to be a more reliable
indicator. In this version of Stochastics the more sensitive %K line is dropped.
The original %D now becomes the slower line %K. The new %D is a 3-day moving
average of the %K. This basically gives you a smoothed version of the original
indictor. This modified counter trend indicator is less reactive but considered
to be more accurate.
Interpretation:
Slow Stochastics are interpreted the same as fast Stochastics. Quite often the
faster of the two indicators moves into and out of the overbought/oversold
regions quite quickly.
