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Username Post: What is Stochastics?
Posts 249
06-23-09 05:38 PM - Post#3281    

Stock market experts use indicators to track the trends of different stocks that they may be interested in, so they can make their purchase or sale decisions. An oscillator is one such tool that helps us compare the latest price of a stock with the trading range that it has experienced during a given time period. More specifically, oscillators serve as trend reversal indicators and let us know when a market is in an overbought or oversold state.

For instance, when the oscillator reaches an extreme high, the market is in the overbought condition, and vice versa. While a strong downtrend is in force, chances are that the oversold position may remain unchanged for some time to come. It is important to assess whether a trend is actually there. If it is so, then it could be a good strategy to use overbought/oversold readings and make your buy/sell decisions in line with the trend. While there exists a strong uptrend, oversold levels can be a good entry point, and overbought levels make a good exit point.

Stochastic is one such popularly used oscillator that helps traders identify the turning points of a stock’s price in either direction. It has to be used in conjunction with the Moving Average Convergeance/Divergeance (MACD), and can be an effective indicator. The basic premise in stochastic is that ‘prices tend to close near their past highs in bull markets, and near their lows in bear markets. Transaction signals can be spotted when the stochastic oscillator crosses its moving average’. (Wikipedia)

George Lane was the first to develop and use stochastic to measure the relationship between the closing price of a stock and its price range over a preset time period.
Stochastic is usually calculated using the following formula:

Source: lator
The stochastic oscillator has a range of 0 to 100 and indicates overbought conditions above 80 and oversold conditions below 20. If the Stochastic hovers near 100, it signals an accumulation phase for the stock, and if it happens to be nearer zero, it indicates a distribution phase. The shape of a Stochastic top or bottom is another indicator of the market trend. A narrow bottom that is not very deep indicates that the ensuing rally is likely to be strong. A broad, deep bottom signals that the stock is bearish and that the rally is likely to be weak. Likewise, a narrow top indicates a strong correction is in the offing.

The oscillator has two lines, the first being the %K which is the measure of the level of momentum behind the oscillator, and the second line being the %D which is just a moving average of the %K.

In most cases, the preceding 14 trading periods are taken into account in the calculation, but this may be adjusted according to need.

Price Action: This refers to the prices at which a stock has traded during the course of a day. One of the principles of stochastic is that the closing price of a stock is likely to be somewhere at the high end of the day’s price action. A stock may have opened at $10.00, traded at a day’s low of $9.10 and a high of $10.90, and closed at $10.50 for the day. The price action of the stock is between $9.10 (the day’s low) and $10.90 (the day’s high). However, in the event the stock is in a downtrend, the closing prices will tend to hover at or near the low of the trading session.
Cons: Although stochastic can be helpful to make your trading decisions based on the overbought and oversold levels in a trading range, the results can be disastrous you are imprudent. During the course of a trend, the oscillators can exhibit the overbought or oversold signs for an extended length of time, but it may not always be prudent to take an oversold reading as a sign that it is time to buy. No oscillator is perfect. There is no fool-proof oscillator that gives 100% accurate readings.
Pros: Stochastic works best when there is a clear trend. When a trader is convinced about the trend's integrity, it makes sense to buy on pullbacks, and stochastic helps in identifying such an opportunity when it arises. Both seasoned traders and new entrants find stochastic to be a useful tool.

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