Leading Technical Indicator - the Stochastics

Technical analysis is practiced in two main categories namely chart patterns and indicators. Indicators are calculations based on the price of a stock/ Index and indicates trends, volatility and momentum. Indicators are often compared to "pulse, pressure check" of a patient by the doctor to assess the extent of the illness. Indicators help you assess the market for its momentum, direction, etc.

Indicators are used as a tool to gain further insight into the supply and demand of securities. Indicators are used to confirm price movement and the probability that the given move will continue. Along with using indicators as secondary confirmation tools, they can also be used as a basis for trading as they can form buy-and-sell signals.

Indicators are of two main types - leading and lagging - both differing in what they show users.

Leading Indicators are those created to precede the price movements of a security giving predictive qualities. Two of the most well-known leading indicators are the Relative Strength Index (RSI) and the Stochastics Oscillator. I have often identified the reversal with the additional help from Stochastics.

Lagging indicator is one that follows price movements and has less predictive qualities. The most well-known lagging indicator is the MACD. The usefulness of this indicator tends to be lower during non-trending periods.

A leading indicator is thought to be the strongest during periods of sideways trading ranges, while the lagging indicators are regarded as highly useful during trending periods and produce fewer buy-and-sell signals which allow the trader to capture more of the trend instead of being forced out of their position.

The stochastic oscillator is calculated as a percentage of a security's closing price to its price range over a given time period. For eg: If a 5 day range of an index is 100 points and the index has closed to day 80 points up from that 5 day low, the stochastic will be 80, near overbought. Similarly if the index closes quite close to the 5 day lows, a mere 20 point away from it, the stochastic is 20, near oversold. The oscillator's sensitivity to market movements can be reduced by adjusting the time period or by taking a moving average of the result. In an upward trend the price should be closing near the highs of the trading range and in a downward trend the price should be closing near the lows of the trading range. When this occurs it signals continued momentum and strength in the direction of the prevailing trend.

This leading indicator will create many buy and sell signals that make it better for choppy non-trending(Sideways) markets instead of trending markets where it is better to have less entry and exit points.

The stochastic oscillator is plotted within a range of 0 and 100 and signals overbought conditions above 80 and oversold conditions below 20. The stochastic oscillator contains two lines. The first line is the %K which is essentially the raw measure used to formulate the idea of momentum behind the oscillator. The second line is the %D which is simply a moving average of the %K. The %D line is considered to be the more important of the two lines as it produces better signals.

There are two main ways this indicator is used to form buy and sell signals are through crossovers and divergence.

Crossovers occur when Stochastic moves up from below 20 or 30 to generate a buy signal or moves down from above 70 or 80 to create a sell set up. It signals that the trend in the indicator is shifting and that this trend shift will lead to a certain movement in the price of the underlying security.

Divergence occurs when the direction of the price trend and the direction of the indicator trend are moving in the opposite direction. This signals that the direction of the price trend may be weakening as the underlying momentum is changing.

There are two types of divergence - positive and negative. Positive divergence occurs when the indicator is trending upward while the security is trending downward. This bullish signal suggests that the underlying momentum is starting to reverse and that traders may soon start to see the result of the change in the price of the security. Negative divergence gives a bearish signal as the underlying momentum is weakening during an uptrend.

When it is combined with EW, the effectiveness increases as during 3rd waves, it tends to remain in the "Overbought" or "Oversold" for longer than usual. During such a 3rd wave, the lagging indicator,Macd, works well.

We, now, have trendlines & Channels, Pivots with supports & Resistances, leading(Stochastics) and lagging(Macd) indicators combination in a Trading system that forms the basis of our "Tech.Table". Note that we are not obsessed by any indicator or any method but each one contributing its worth as in a "Cohesive TEAM" that can lead you into any challenging trading day. What is the one most important team member missing.? The strategist who can peek into the opponents (Market's) next move. We will cover next the Strategist, Elliott wave.