The Stochastic oscillator was made popular by George Lane. It is formulated on the evidence that as prices increase, closing prices tend to be closer to the upper end of the price range. The reverse of that is that, in downtrends, the closing price tends to be near the lower end of the range. There are two lines used in this process on the chart….the %K line and the %D line. The %D line is the important one since it provides the major signals.
The objective is to determine where the most recent closing price is in relation to the price range for a particular time period. Fourteen days is a popular time period to use and so the formula for the K line becomes:
%K=100 ((C-L14)/(H14-L14))
C is the latest close, L14 is the lowest low for the 14 periods, and H14 is the highest high for the same period. The periods can refer to days, weeks or months.
The chart will then show up as an oscillator with a measurement range of 0 to 100. A high reading of over 80 would put the closing price near the top of the range while a low reading of under 20 would put the closing price near the bottom of the range. The eyeball extremes are therefore marked as 80 and 20.
The second line (%D) is a three period moving average of the %K line. This formula produces a version called fast stochastics. By taking another three period average of %D, a smoother version called slow stochastics is then computed. Slow stochastics is more reliable.
Two lines are produced that oscillate between a scale from 0 to 100. The K line is the fast line while the D line is slower. A bearish divergence occurs when the K line is over 80 and forms two declining peaks while prices continue to move higher. A bullish divergence is when the K line is under 20 and forms two rising bottoms while prices continue to go lower. Of course, a simplistic use is merely to consider it overbought when the K line goes over 80 or oversold when it goes under 20.
The average investor can find much value in this oscillator by simply looking for the faster K to cross over the D line. It is this crossing over of the faster line over the slower line that gives the buy or sell signal. The more extreme the reading, either toward 100 or toward 0, the stronger becomes the signal.
The reliability of this oscillator has been proven over time. Although it cannot be 100% guaranteed, it does remain one of the best and can be used effectively in coordination with other oscillator indicators for verification purposes.
The MACD was developed by Gerald Appel. There are two lines to be seen on the oscillator graph although three lines are actually used in the computation. The faster line is the MACD line and is the difference between two exponentially smoothed moving averages of closing prices usually the last 12 and 26 days. The slower line called the signal line is usually a 9 period exponentially smoothed average of the MACD line.
The actual buy and sell signals are given when the two lines cross. A crossover by the faster MACD line above the slower signal line is a buy signal. A crossover by the faster line below the slower is a sell signal. The MACD values move above and below a zero line. An overbought situation is present when the oscillator lines are far above the zero line. An oversold situation is when the lines are far below the zero line. The strongest signal will occur when there is a crossover well above or below the zero line.
The MACD oscillator works well in conjunction with the stochastic oscillator. The best buy or sell signal is given when MACD verifies a stochastics signal. Everyone who trades stock or is concerned about market direction should use these two oscillators with the price chart. This process works not only with individual stocks but with all the major averages as well.
The use of moving averages is essential in order to complete a simple well-rounded analysis program for the average investor. At least three averages should be used and these can be incorporated into most charting systems including the program at bigcharts.com. It would be foolish not to use these averages.
Let us consider the triple crossover method. One of the most popular methods used in futures and commodities and even stocks is the 4 day, the 9 day and the 18 day moving average. For stocks, I recommend using either 10-20-50-day, or 20-50-100-day or perhaps even keep tabs on both methods. The mode of operation here is called the triple crossover method.
Keep in mind that the 20-day average will follow the trend much closer than the 50-day or 100-day average. Therefore, the shorter term average will move the quickest. This leads to a process called crossover. This means that when a fully intact uptrend is in process the 20-day will be above the 50-day which will in turn be above the 100-day. In a full downtrend, the average lines will be in reverse order. A bullish signal is given while in a downtrend the 20-day average line crosses above the 50-day and then a full confirmation occurs when the 20-day crosses above the next average line which may be the 100-day. Whenever an uptrend reverses, it will be the 20-day average line that will cross below the 50-day and so-forth.
Naturally, the 4-9-18 method is to be considered aggressive and perhaps less accurate while the 20-50-100 method is more conservative but more accurate. By using moving averages in conjunction with stochastics and MACD, you can determine whether to buy or sell or hold. Whether to buy or sell aggressively will depend on whether or not all of oscillators are indicating the same signal in coordination.
RSI: RELATIVE STRENGTH INDEX
Indicators Explained