It would be nice to be able to look at volume or the time and sales numbers and feel confident they contain valid and valuable information, but in practice they are of little help. Seeing the huge euro offers on Friday, you might have wanted to jump on the euro-selling bandwagon, but depending on where you entered, chances are good you would have racked up a loss by the close.
Where the price closes relative to the open and to the high-low range is still the safe way to judge the balance of supply and demand — what actually happened, rather than what some player wanted to happen. When the close is near the high, the bulls won that day, and when it’s near the low, the bears won that day. If the close is exactly at the high or low, it was a rout. Because most people close out positions before the very end of the trading session, bulls or bears are sending a strong message to the market when they force the close to be at the exact high or low.
One of the objectives of strong bulls in forcing the close at the exact high or low is to influence certain technical indicators, especially if they can achieve a close in the top 30 percent of the bar over a series of days. Closes near the high over three or five days suggest to all observers that sentiment is not only bullish, but growing more so. Market-leading bulls want to nudge the bar components to show not only direction, but momentum as well. Higher highs and higher closes accompanied by higher lows constitute an uptrend, but the key factor is the slope of the move — its steepness. The steeper the slope, the more chance the bull has of luring other traders into the market.
Many traders like to use the stochastic oscillator as a reflection of this kind of bar analysis. This indicator measures the distance between today’s close and the lowest low of the past x days, and divides that by the high-low range over the same x number of days. This ratio is multiplied by 100, making the indicator range between zero and 100, but more often, between 30 percent and 70 percent of the total possible range. When today’s close is higher than yesterday’s close, it’s farther away from the lowest low and thus a higher number, and when you divide that by the range, you still get a higher number. This denotes higher momentum, but at some point, the currency becomes “overbought,” meaning that relative to the normal range, it has gone as high as it is likely to go.
The opposite is true, too. When you have a lower low and subtract it from the lowest low over the past x days and then divide by the range, you get a lower number, one that approaches the “oversold” level. It shows that when the euro was oversold in November and late December (circles), the euro subsequently rose (arrows). Then the euro was oversold again in February, and despite the price having broken the red support line to the downside, shouldn’t we expect it to rise?
Overall, the net effect of the stochastic oscillator is to disclose demand in a rising market and hide supply in a falling one.
Therefore, when there is massive supply (as shown on Globex time and sales on Feb. 17) but it fails to move the oscillator downward, we should worry.
Or should we? If you reproduce using 60-minute bars instead of daily data, you see the stochastic oscillator at the overbought line — not rising up off the oversold line. The same is true of the 180- minute chart and the 360-minute chart. And that’s a real problem with the indicator — it’s not really a reversal indicator when a big trend is in force. It may be handy if you’re an intraday trader, but you shouldn’t count on it on a daily chart. Consider the Japanese yen. From a peak in January 2005, it fell to a new low in December 2005, a move of over 1,600 points and a fat profit for anyone who could hold a short position through the entire period. No one would dispute this is a trend with a capital T.
If you had imagined the trend was ending each time the stochastic oscillator turned up, signaling an end to the oversold condition, you would have missed making a stupendous gain. During October and November, for example, the price was in an especially strong and continuous down move (arrow), but the stochastic oscillator kept rising up off the oversold line (ellipse). The stochastic oscillator was measuring only minor variations in the context of a major continuing trend. This is mostly an arithmetic issue — the formula uses the high-low range over the past x days.
When that is very small to begin with, any new high appears disproportionately bigger relative to the lowest low. You get a bottom in the indicator that is not a bottom in the price. In fact, look at the same chart in a weekly format. On this chart, the stochastic was finally right about a crossover indicating a reversal move, which lasted six periods before indicating an overbought condition and resumption of the existing trend. If you were looking at a weekly chart, it would have delivered good guidance. The same thing holds for the weekly euro chart. The stochastic oscillator correctly identified a down move, an up move and another down move — all in the context of an overall year long down move, although not one as consistent as the Japanese yen down move.
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