|The fast, slow and full stochastic|
The fast, slow and full stochastic
Oscillators work on the premise that markets tend to over extend themselves on both sides of the scale. Whether these extreme conditions are described as overbought or oversold (momentum), strength (trend) or something else, it is when these extremes are reached that it is assumed the market is in a position to begin a correction (minor or major). These extreme values in oscillators tell us when to be watchful of the ever dreaded and inevitable trend reversal.
Oscillators also give us information about the general trend. As trend analysis works with the price line, trend analysis is also a valuable part of analyzing an oscillator. This is where part of the "predictive" abilities of oscillators are seen. These events are also known as convergences and divergences. This is when the trend of the oscillator has broken before the price trend, and they are no longer moving in parallel.
Here are some general rules to use when applying your oscillator of choice
By using all the information provided within an oscillator, these types of technical indicators can be a valuable tool in the technical analysis arsenal. In this newsletter we will be focusing on the Stochastic indicator.
The stochastic, the fast, the slow and the full.
The fast (original)
There are three types of generally accepted stochastic formulas. The original stochastic oscillator was developed by Dr. George Lane and is referred to as the fast stochastic. The stochastic's formula (%K) is based on two observations made by Dr. Lane.
(fast stochastic (9,3) on Dow Jones Industrial Average, 1 year chart, captured July 17, 2005)
The stochastic has two lines, the %K and the %D. The %K is the plotted instrument (see observations) while the %D is the moving average of the %K. The %K is more sensitive and it is the %D line that triggers the trading signals.
(slow stochastic (9,3) on Dow Jones Industrial Average, 1 year chart, captured July 17, 2005)
Some traders felt that the %K line was overly sensitive. To correct this issue they smoothed the %K line. This was done by plotting a 3 day sma of the %K line rather than the original (fast) %K. The new %D line would be calculated by the new (slow) %K.
What does all that mean? Just that the new slow stochastic is a smoothed (averaged) fast stochastic. Have a look at the following graph,
Then the full stochastic was created. Rather than being forced to use the 3 day SMA of the %K as in the slow stochastics, traders felt that this should be a variable. This created the third variable called the smoothing variable. This changes the amount of days to be used in the smoothing average of the %K.
You can also recreate the fast and the slow stochastic by the full stochastic.
To mimic the fast stochastic, use a 1 day smoothing number. To mimic the slow use a 3 day smoothing number.
Since the fast stochastic %K line is quite sensitive, it generates quite a few signal line crosses (%K crosses %D) while the slow stochastic is a little more frugal in it's dispensing of line cross signals. It is extremely important with any type of stochastic to evaluate the strength of signal generated. Here are some good tips to help decipher what is a good signal
Example of a strong signal(s)
In this example, all the stages are met,
TIPS & TECHNIQUES - Using the stochastic
When using stochastics be mindful of the effects the different parameters make on the signals that are returned when screening. The general rule of thumb is that the larger the parameter, the less sensitive the indicator becomes, the smaller the parameter the more sensitive the indicator is.
The first stochastic is a slow stochastic(9,3), the is a slow stochastic (21,9). As you can see the larger the parameter the smoother and less sensitive the stochastic becomes.