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STOCHASTIC
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Stochastic is an oscillator popularized by George Lane . It is now included in many software programs and widely used by computerized traders. Stochastic tracks the relationship of each closing price to the recent high-low range.

Stochastic is more complex than Williams %R. It includes several steps for filtering out market noise and weeding out bad signals. Stochastic consists of two lines: a fast line called %K and a slow line called %D.

The standard width of Stochastic's time window is 5 days, although some traders use much higher values. A narrow window helps catch more turning points, but a wider window helps identify major turning points.

There are two ways to plot Stochastic—Fast and Slow. Fast Stochastic consists of two lines—%K and %D—plotted on the same chart. It is very sensitive to market turns but leads to many whipsaws. Many traders prefer a less sensitive Slow Stochastic. The %D of Fast Stochastic becomes the %K of Slow Stochastic and is smoothed by repeating step 2 to obtain %D of Slow Stochastic. Slow Stochastic does a better job of filtering out market noise and leads to fewer whipsaws. A 5-bar Slow Stochastic (smoothed over a 3-day period) is a popular choice among traders (see worksheet, Figure 30-1).

Stochastic is designed to fluctuate between 0 and 100. Reference lines are drawn at 20 percent and 80 percent levels to mark overbought and oversold areas. Slow Stochastic seldom reaches the same extremes as raw Williams

Crowd Psychology

Each price is the consensus of value of all market participants at the moment of transaction. Daily closing prices are important because the settlement of trading accounts depends on them. The high of any period marks the maximum power of bulls during that time. The low of that period shows the maximum power of bears during that time.

Stochastic measures the capacity of bulls or bears to close the market near the upper or lower edge of the recent range. When prices rally, markets tend to close near the high. If bulls can lift prices up during the day but cannot close them near the top, Stochastic turns down. It shows that bulls are weaker than they seem and gives a sell signal.

Daily closes tend to occur near the lows during downtrends. When a bar closes near its high, it shows that bears can only push prices down during the day but cannot hold them down. An upturn of Stochastic shows that bears are weaker than they appear and flashes a buy signal.

Trading Rules

Stochastic shows when bulls or bears become stronger or weaker. This information helps you decide whether bulls or bears are likely to win the current fight in the market. It pays to trade with the winners and against the losers.

Stochastic gives three types of trading signals, listed here in the order of importance: divergences, the level of Stochastic lines, and their direction (Figure 30-2).

Divergences

The most powerful buy and sell signals of Stochastic are given by divergences between this indicator and prices.

•  A bullish divergence occurs when prices fall to a new low but
Stochastic traces a higher bottom than during the previous decline. It
shows that bears are losing strength and prices are falling out of iner
tia. As soon as Stochastic turns up from its second bottom, it gives a
strong buy signal: Go long and place a protective stop below the latest
low in the market. The best buy signals occur when the first bottom is
below the lower reference line and the second is above it.

•  A bearish divergence occurs when prices rally to a new high but
Stochastic traces a lower top than during its previous rally. It shows

that bulls are becoming weaker and prices are rising out of inertia. As soon as Stochastic turns down from its second top, it gives a sell sig­nal: Go short and place a protective stop above the latest price peak. The best sell signals occur when the first top is above the upper reference line and the second is below.

Overbought and Oversold

When Stochastic rallies above its upper reference line, it shows that the market is overbought. Overbought means too high, ready to turn down. When Stochastic falls below its lower reference line, it shows that the market is oversold. Oversold means too low, ready to turn up.

These signals work fine during trading ranges but not when a market develops a trend. In uptrends, Stochastic quickly becomes overbought and keeps giving sell signals while the market rallies. In downtrends, Stochastic quickly becomes oversold and keeps giving premature buy signals. It pays to combine Stochastic with a long-term trend-following indicator (see Section 43). The Triple Screen trading system allows traders to take buy signals from daily Stochastic only when the weekly trend is up. When the weekly trend is down, it allows traders to take only sell signals from daily Stochastic.

3. When you identify an uptrend on a weekly chart, wait for daily
Stochastic lines to decline below their lower reference line. Then,
without waiting for their crossover or an upturn, place a buy order
above the high of the latest price bar. Once you are long, place a pro­
tective stop below the low of the trade day or the previous day,
whichever is lower.

The shape of Stochastic's bottom often indicates whether a rally is likely to be strong or weak. If the bottom is narrow and shallow, it shows that bears are weak and the rally is likely to be strong. If it is deep and wide, it shows that bears are strong and the rally is likely to be weak. It is better to take only strong buy signals.

4. When you identify a downtrend on a weekly chart, wait for daily
Stochastic lines to rally above their upper reference line. Then, with­
out waiting for their crossover or a downturn, place an order to sell
short below the low of the latest price bar. By the time Stochastic lines
cross over, the market is often in a free fall. Once you are short, place

a protective stop above the high of the trade day or the previous day, whichever is higher.

The shape of Stochastic's top often indicates whether a decline is likely to be steep or sluggish. A narrow top in Stochastic shows that bulls are weak and a severe decline is likely. A Stochastic top that is high and wide shows that bulls are strong—it is safer to pass up that sell signal.

5. Do not buy when Stochastic is overbought and do not sell short when it is oversold. This rule filters out most bad trades.

Line Direction

When both Stochastic lines are headed in the same direction, they confirm the short-term trend. When prices rise and both Stochastic lines rise, the uptrend is likely to continue. When prices slide and both Stochastic lines fall, the short-term downtrend is likely to continue.

mechanical manner, buying and selling when the two Stochastic lines cross. They discard Stochastic when it fails to deliver magic results. Trading the crossovers of Stochastic lines is not profitable, no matter how much you optimize them, because Stochastic works differently, depending on whether the market is in a trend or in a trading range.

More on Stochastic

Stochastic can be used in any timeframe, including weekly, daily, or intra- day. Weekly Stochastic usually changes its direction one week prior to weekly MACD-Histogram. If weekly Stochastic turns, it warns you that trend-following MACD-Histogram is likely to turn the next week. It is a signal to tighten stops on existing positions or start taking profits.

Choosing the width of the Stochastic window is important. Short-term oscillators are more sensitive. Long-term oscillators turn only at important tops and bottoms. If you use Stochastic as a stand-alone oscillator, a longer Stochastic is preferable. If you use Stochastic as part of a trading system, combined with trend-following indicators, then a shorter Stochastic is preferable.

An ingenious way to use Stochastic, popularized by Jacob Bernstein, is called a Stochastic pop. When Stochastic crosses above its upper reference line, it indicates strength. You can buy for a quick rally and sell as soon as Stochastic turns down. This signal can help you catch the last splash of the bullish wave.

Stochastic is one of the favorite tools of automatic trading systems developers. These modern-day alchemists try to use Stochastic

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