Technical Indicators – IV- Stochastic Oscillators

One of the most time honored technical indicators for determining the degree of overbought/oversold of a security is the Stochastic oscillators. Stochastic oscillators are complicated in calculation and diverse in their interpretation.

Traditionally Stochastic oscillators are plotted with at least two lines – called percent K and percent D. Percent K being the Stochastic calculation and percent D being a moving average of percent K – often referred to as the signal line.

Over many years of empirical analysis I have determined that for short term treading the following configuration of Stochastic oscillators works best for my trading method.

I plot percent K only – three times – employing a different number of bars for each plot. The number of bars is 7, 28 and 84 – which means that I plot a very fast, medium and long percent K.

The resulting plot, shown in Figure 1, uses red, green and blue lines to represent the 7, 28 and 84 period Stochastic calculations.

The advantage is that I have an overbought picture for the very short term and for two increasingly longer terms.

Figure 1

When I plot the Stochastic oscillators on three different time frames on intra-day charts I have a comprehensive picture of overbought/oversold.

Stochastic oscillators range in value between a maximum of 100 and a minimum of 0..

When all three Stochastic lines are at an extreme value – near 0, the market is very oversold – or near 100 the market is very overbought.

Overbought and oversold conditions may exist for a substantial length of time – or a very brief period of time.

The red line – being the fastest – will oscillate from 0 to 100 frequently. The green and blue lines – being much slower seldom actually reach the 0 or 100 value, but may get very near it.

The Stochastic oscillator is a very important part of our overall technical trading system – but a classic example of why no one indicator – no matter how good it is at any given time – is usually not sufficient to trade with all by itself.

The five white dotted vertical lines on the above chart mark several price turning points that may have provided good trading opportunities. Note the red Stochastic reverses at each of those lines but the green and blue lines generally just move slowly down with very little oscillation.

We have created a special alert which is based on the Stochastic oscillators and it is included in our custom indicator package for TradeStation. Not all of the alerts result in tradable oscillations – but each is worth noting because about 50% are excellent trading opportunities.