Don’t oscillate on using stochastics

Philip Salter
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STOCHASTIC oscillators can be wielded in the constant battle against the random walk of the market. As with all technical analysis tools, they won’t unlock all the secrets of the price action, but they can be an additional clue as to the statistical likelihood that the market is due a correction on the downside or upside.

Elliott Winner of Capital Spreads explains that at the basic level stochastic oscillators are “used to work out when the market is overbought or oversold.” In essence, they are a tool for traders to compare an asset’s closing price to its price range over a given time period. They work on a scale running from 0 to 100 per cent. Winner explains: “If the stochastic lines move above 80 it means the market is overbought, and if it moves below 20 it means the market is oversold.

Developed by market technician George C. Lane in the late 1950s, stochastic oscillators are one of the most popular technical analysis tools for traders. Sandy Jadeja of City Index says: “As with any technical indicator, the indicator will never be 100 per cent correct in the given signals at the time, but the signals can be used to gain an edge.”

Caution is a must. CMC Market’s Michael Hewson thinks before traders dive in, they need to know the basics of trend lines support and resistance – “it’s like trying to put the first floor in before building the foundations.” Otherwise there is a risk that traders won’t be trading with the trend.

All platforms provide software that plot stochastic oscillators, yet traders should understand how it is worked out, particularly as they will need to tweak the timeframes over which they work. Although slightly more complicated in practice, the following formula gives the relevant facts of the relations between the different statistics:

Stochastic oscillator % = 100 x (recent close – lowest low) / (highest high – lowest low)

In order to smooth out the data, “slow” and “full” stochastic oscillators use moving averages to smooth out the bumps, giving a cleaner view of price action and momentum. Platform providers allow traders to add a “slowing value.”

The time frames and moving averages can be amended. David Jones of IG Markets explains: “The text book setting are 5-3-3 for a five-day stochastic and 10-6-6 for a ten day version.” The first number is the number of days taken into account for the calculation, while the next two numbers are in effect moving averages, says Jones. As such, 5-3-3 is a five-day stochastic and the first line plotted is a three day moving average of the first value and the next three is a three-day moving average of the three-day moving average.

Spread Co’s Ian O’Sullivan says “stochastics, like most other technical analysis tools should be used in collaboration with other tools such as moving averages or Fibonaccis.” O’Sullivan thinks stochastic oscillators should be used as a component of your decision making when looking to take (or close) a position. As such, he says you should use stochastics “if you are looking to sell short near a resistance area, or a key Fibonacci level.” Stochastic oscillators add to the evidence for or against a trading decision. O’Sullivan describes them as offering “a little bit of back-up support.”

Hewson provides the graph (below), which shows how to use resistance lines in conjunction with stochastic oscillators. Euro-dollar reached a turnover point at $1.38733 – the confluence of trend line resistance with a stochastic reading of around 70 per cent implied that this was time to go short.

But it’s easy to be a Monday night quarterback. Hewson warns traders “not to design a system that just works historically.” He says it would be a mistake to change the time frames to fit with past data, “decide on a trading system and stick with it.” Jones thinks “the best way to learn how these work is to put them on some charts and watch to see how it would fit in with your own trading approach.”

Rather than using a standalone solution of buying on overbought and oversold conditions, Jadeja suggests traders utilise the stochastics as a potential trend indicator and combine price patterns alongside to seek better results. He also thinks “using any indicator on just one timeframe could prove disastrous” – multiple timeframes should yield better results. He therefore suggests that traders “use a weekly chart plotted with a stochastic indicator to provide the dominant trend and use a lower time frame such as a daily chart for entries and exits.”

Jadeja also offers sound and sober advice on technical analysis to anyone new to trading: “Every trader is looking for an edge. Typically a newcomer will be led to believe that there is some unique indicator or magical formula that will deliver significant profits.” However, he concludes: “After searching for the mystical holy grail the trader will eventually realise that the search is likely to end where it started – the start of a new search of something different.”