Technical Perspective: Using Stochastics to Help Advisors Navigate the Markets and Stock Positioning.

The Stochastic Oscillator (Stochastics) is one of the commonly used technical indicators by market participants. It is core to our work here at The Fred Report and if you are going to read us each week, then it is necessary to understand how they work.

Stochastics are momentum oscillators and are standard on many charting programs and we feel could be used by everyone who is buying and selling stocks. There are two lines that make up a Stochastic Oscillator and can be found on the chart below. These lines are the %K and %D.

%K is the faster of the two lines and represents a mathematical formula that measures where the current close is in relation to the trading range of the last “X” periods of time. We use a 14 period look-back, so in plain English %K says where the current close is in the trading range of the last 14 days, expressed as a %. The other line, %D, is a 3 period moving average of %K so effective a second derivative for those familiar with calculus.

At The Fred Report we use Stochastics somewhat differently than is commonly taught. The standard way to use the indicator is to register a buy signal when it moves below, and then above, 20 (the lowest 20% of closing prices in the last 14 days). A sell signal is when the indicator moves above, and then below 80 (the highest 80% of closes over the last 14 days). We also look at Stochastics on a weekly and monthly basis as well to help us with bigger trends. So, in those cases we would look at 14 weeks or months.

We have found that the Stochastic is sensitive, so we use it to add to stocks that are in a portfolio and not as a way to determine the ultimate top or bottom in the name. After all, most advisors do not buy or sell stocks for technical reasons – rather they use stocks in a portfolio based on firm recommendations. This technique does give an excellent chance of buying a good fundamental recommendation at a good price, however. When looking at the standard The Fred Report chart, you will note that most buy signals occur when the 5 period moving average (see our Moving Averages video for the MTA) is below the 20 period moving average, i.e. the trend is still down. If the moving averages do not cross soon after, the stochastic signal will most likely not work. Having the moving averages cross after the stochastic signal confirms that signal. A new price low after the stochastic signal would suggest that the prior trend remains in effect. Most advisors exit positions for reasons other than technicals – most often because of a rating change or other factor. The Stochastic is sensitive, and it can give early indications, especially in new trends. We reiterate that we use stochastics in portfolio management, but they are not the best indicator to use for establishing ultimate bottoms or tops. We have several proprietary indicators that work better for this.