Ranges, trends and stochastics

The stochastic is designed to indicate when a market is overbought or oversold. A stochastic displays two lines, %K and %D. The %K line is calculated by finding the highest and lowest point in a trading period and then finding where the current close is in relation to that trading range; %D is a moving average of %K. We’ll be using the following stochastic parameters: 14 period for the basic lookback period and three days for both of the moving average smoothings (a “14,3,3” stochastic). For more information on this indicator, please see the sidebar, “Stochastic basics.”

It is a weekly chart of the Euro/U.S. dollar currency pair (EUR/USD), along with the 14-period
stochastic oscillator. It shows how during trading ranges (such as the one from June 2000 to January 2002) high stochastic readings tend to coincide with price highs while low stochastic readings tend to accompany price bottoms.

A traditional overbought (sell) signal occurs when the stochastic is above 80 and the %K line crosses below the %D line, which happened in both January and September 2001. These events coincided with market peaks. Conversely, the traditional oversold buy signal occurs when the %K line crosses above the %D line when the stochastic is below 20. The first buy signal occurred in May 2000.

There are times when the stochastic buy signal crossover may repeat before the final price low occurs. For example, a buy signal occurred in September 2000, but it turned out to be early, as the market subsequently made a lower low. In early November, the stochastic flashed a second buy signal.

This same pattern of back-to-back buy signals occurred in early April 2001. The second buy signal was two weeks ahead of the final low in the first week of July 2001. The next stochastic buy crossover occurred in early December, but the trend made one more new low and, again, another buy signal occurred in February 2002. Although our eyes are naturally drawn to the signals that work well in the trading range, the subsequent uptrending period highlights an attribute of the stochastic
oscillator that many people overlook: When a market trends, the stochastic can, in fact, confirm the trend by failing to reach the extreme levels counter to the trend. In other words, if the market is in an uptrend, the stochastic will reach the overbought level but fail to make oversold readings. An uptrend
is, in a way, a persistent overbought state.

The stochastic pushed into overbought territory in April 2002 and never declined below 20 again until August 2003. The market simply continued to zigzag in an uptrend; the upward shift in the stochastic readings (where the %K crossed back above %D when the indicator was at relatively high levels, such as occurred in November 2002) was a sign of strength.