Stochastic Momentum Index Indicator

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Which Indicators Work Best?

08/03/2020 10:42 am EST

President & CEO, TheTradingBook.com

Professional trader Anne-Marie Baiynd unveils the one most important indicator to use, plus discusses the few others that every trader should be watching.

Traders have plenty of technical indicators to choose from, but which are the ones that we should be using? We’re talking about that today with Anne-Marie Baiynd. Anne-Marie, you have a few ideas on that topic.

I do, I do. I think the most important technical indicator of all is the one people sort of ignore—price. Price is the most important thing, because every other technical indicator we look at is a derivative of price. So the more esoteric your indicators become—the farther away they’re developed from price—the less reliable they’re going to be.

So if you always look at technical indicators in terms of is this thing confirming the price event, and look at what’s happening from that perspective. A lot of folks go alright, well I’m going to trade the 820 cross. Well, does the price actually tell you that you should trade the 820 cross? Because it’s the price that’s going to tell you first, because the price makes the technical indicator.

Why do you think people overlook price then?

I think there’s a tendency for folks to look for the next big thing. I just want something that says buy right here. And I think people overlook price because sometimes they think it’s too difficult, because they’re looking at it in too much of a granular fashion. They’re looking in every single penny rather than hey, it’s moved up. If it pulls back, is it pulling back into support? Is it pressing up into resistance? What’s it actually doing right there? That sort of makes people have to think a little bit more, as opposed to the green arrow says it crossed the 820 so I need to buy.

So Anne-Marie, I understand what you’re saying about the importance of price, but I know that you also have some other indicators that you do use regularly.

Yes. I use the moving average. Again, not a fancy indicator. It’s been around for a long time, but it is very, very powerful. Listen, if your candlesticks are printing above your moving average, you probably shouldn’t be short. If it’s sitting below the moving average, you probably shouldn’t be long, right?

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The next one I like is the Stochastic Momentum Index, because it measures divergence. Because after a while price doesn’t really like to move far away from the moving average. They have a tendency to want to converge together. So the candlesticks, after they stretch too far away, they’ll start coming back and a Stochastic Momentum Index really does help us do that.

The other one I really like is the Commodity Channel Index, interestingly enough. I think it was built just to work in the commodities market, but it is very, very good at telling you when price is getting ready to move in an opposite direction. Really good, I like that one a lot.

Thank you so much for sharing your insights with us today.

Stochastic Oscillator Definition

What Is A Stochastic Oscillator?

A stochastic oscillator is a momentum indicator comparing a particular closing price of a security to a range of its prices over a certain period of time. The sensitivity of the oscillator to market movements is reducible by adjusting that time period or by taking a moving average of the result. It is used to generate overbought and oversold trading signals, utilizing a 0-100 bounded range of values.

Key Takeaways

  • A stochastic oscillator is a popular technical indicator for generating overbought and oversold signals.
  • It was developed in the 1950s and is still in wide use to this day.
  • Stochastic oscillators are sensitive to momentum rather than absolute price.

The Formula For The Stochastic Oscillator Is

 %K = ( C − L14 H14 − L14 ) × 1 0 0 where: C = The most recent closing price L14 = The lowest price traded of the 14 previous trading sessions H14 = The highest price traded during the same 14-day period %K = The current value of the stochastic indicator \begin &\text<\%K>=\left(\frac <\text— \text> <\text— \text>\right)\times100\\ &\textbf\\ &\text\\ &\text\\ &\text\\ &\text\\ &\text<14-day period>\\ &\text<\%K = The current value of the stochastic indicator>\\ \end ​ %K = ( H14 − L14 C − L14 ​ ) × 1 0 0 where: C = The most recent closing price L14 = The lowest price traded of the 14 previous trading sessions H14 = The highest price traded during the same 14-day period %K = The current value of the stochastic indicator ​ 

%K is referred to sometimes as the slow stochastic indicator. The «fast» stochastic indicator is taken as %D = 3-period moving average of %K.

The general theory serving as the foundation for this indicator is that in a market trending upward, prices will close near the high, and in a market trending downward, prices close near the low. Transaction signals are created when the %K crosses through a three-period moving average, which is called the %D.

Stochastic Oscillator

What Does The Stochastic Oscillator Tell You?

The stochastic oscillator is range-bound, meaning it is always between 0 and 100. This makes it a useful indicator of overbought and oversold conditions. Traditionally, readings over 80 are considered in the overbought range, and readings under 20 are considered oversold. However, these are not always indicative of impending reversal; very strong trends can maintain overbought or oversold conditions for an extended period. Instead, traders should look to changes in the stochastic oscillator for clues about future trend shifts.

Stochastic oscillator charting generally consists of two lines: one reflecting the actual value of the oscillator for each session, and one reflecting its three-day simple moving average. Because price is thought to follow momentum, intersection of these two lines is considered to be a signal that a reversal may be in the works, as it indicates a large shift in momentum from day to day.

Divergence between the stochastic oscillator and trending price action is also seen as an important reversal signal. For example, when a bearish trend reaches a new lower low, but the oscillator prints a higher low, it may be an indicator that bears are exhausting their momentum and a bullish reversal is brewing.

The stochastic oscillator was developed in the late 1950s by George Lane. As designed by Lane, the stochastic oscillator presents the location of the closing price of a stock in relation to the high and low range of the price of a stock over a period of time, typically a 14-day period. Lane, over the course of numerous interviews, has said that the stochastic oscillator does not follow price or volume or anything similar. He indicates that the oscillator follows the speed or momentum of price. Lane also reveals in interviews that, as a rule, the momentum or speed of the price of a stock changes before the price changes itself. In this way, the stochastic oscillator can be used to foreshadow reversals when the indicator reveals bullish or bearish divergences. This signal is the first, and arguably the most important, trading signal Lane identified.

Example Of How To Use The Stochastic Oscillator

The stochastic oscillator is included in most charting tools and can be easily employed in practice. The standard time period used is 14 days, though this can be adjusted to meet specific analytical needs. The stochastic oscillator is calculated by subtracting the low for the period from the current closing price, dividing by the total range for the period and multiplying by 100. As a hypothetical example, if the 14-day high is $150, the low is $125 and the current close is $145, then the reading for the current session would be: (145-125)/(150-125)*100, or 80.

By comparing current price to the range over time, the stochastic oscillator reflects the consistency with which price closes near its recent high or low. A reading of 80 would indicate that the asset is on the verge of being overbought.

The Difference Between The Relative Strength Index (RSI) and The Stochastic Oscillator

The relative strength index (RSI) and stochastic oscillator are both price momentum oscillators that are widely used in technical analysis. While often used in tandem, they each have different underlying theories and methods. The stochastic oscillator is predicated on the assumption that closing prices should close near the same direction as the current trend. Meanwhile, the RSI tracks overbought and oversold levels by measuring the velocity of price movements. In other words, the RSI was designed to measure the speed of price movements, while the stochastic oscillator formula works best in consistent trading ranges.

In general, the RSI is more useful during trending markets, and stochastics more so in sideways or choppy markets.

Limitations Of The Stochastic Oscillator

The primary limitation of the stochastic oscillator is that it has been known to produce false signals. This is when a trading signal is generated by the indicator, yet the price does not actually follow through, which can end up as a losing trade. During volatile market conditions this can happen quite regularly. One way to help with this is to take the price trend as a filter, where signals are only taken if they are in the same direction as the trend.

Stochastic Momentum Index Indicator

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