Technical Indicators: Fast and Slow Stochastic

Posted by Dan Hung

December 9, 2006

The stochastic oscillator is another technical indicator designed to oscillate in a range of numbers (0 to 100) and tells the reader whether or not the stock is overbought or oversold. It looks vaguely similar to MACD in the sense that there are two lines graphed on the graph and signals are often made when one line crosses the other. The primary curve on the stochastic is called the %K line (on bigcharts.com it is the red line). It is determined through the equation 100 * (recent close - lowest close(n)) / (highest high(n) - lowest low(n)). In this equation, n stands for the number of days in the period for the stochastic indicator and, as you can see from the equation, %K represents the proportion level of where the stock price is trading relative to the stock price’s range over the period of n days. The %D line (on big charts.com it is the blue line) acts as the signal line and is determined by the 3-day simple moving average of the 3-day simple moving average of %K (sounds a little weird right? well… you’ll see why…)

There are three kinds of stochastic indicators - fast, slow, and full. On bigcharts.com, the only options for their charts are fast and slow so those are what I will be discussing today. Basically, the fast stochastic is designed to use the exact %K line described above. The slow stochastic attempts to smooth this primary curve by taking the 3-day simple moving average of the %K line and using this as the primary curve. In my experience, slow stochastic tends to be much more readable because fast stochastic is much more sensitive and prone to false signals.

If you take a look at the graph above, I have a stock price chart along with the fast stochastic and then the slow stochastic beneath it. Using the stochastic indicator is quite simple. It is similar to MACD in that there are ranges which signal that a stock is overbought or oversold. In the case of stochastics, the overbought region is >80 and the oversold region is <20. As always, but in the stochastic indicators especially, the regions of overbought and oversold do not necessarily mean that a stock will begin to rise or fall simply because it has reached these extremes. Instead, you will often notice what I like to call the "stochastic bounce" during trending periods where the stochastic will fluctuate in an overbought or oversold region for the duration of the up or down trend. This bounce is not as noticeable in the above graph, but a small example might be the area on the fast stochastic curve between the middle of October and November while the stock in question is depreciating.

The stochastic indicator does a good job at predicting trend reversals as during a bounce you may begin to notice the stochastic developing a trend of its own that is in a direction opposite of the trend. This is known as a divergence because the stochastic graph is diverging with the movement of the price chart. A good example of this is the period that I have marked showing the stock's uptrend in June and peak in July. As you can see, the stochastic indicators climb with the uptrend and then bounce around the 80 line but, as the stock climbs higher, the stochastic does not making a corresponding high. This divergence is a big signal that the trend is about to reverse and usually a good sell point. The day after, the stock begins to tumble and the stochastic drops out of the overbought zone (under 80) at which point any good investor would know to get out and lock in their gains.

The most redeeming quality for using the stochastic indicator is that it is very sensitive to daily price movement and as such it is a somewhat conservative signaler for sell points but a very optimistic signaler of buy points. While I have described an uptrends and sell signals using the stochastic indicator, the same logic in reverse will work for trying to spot reversals of downtrends and buy signals. In my opinion, there are other charts that can be used to predict buy points more accurately than the stochastic oscillator (especially the stochastic graphs on bigcharts.com for reasons that I will discuss in the next paragraph).
To be honest, the stochastic indicator feature on bigcharts.com's advanced and interactive chart is likely one of my least favorite. Not because stochastic indicators are inaccurate but because its default period is only 5-days. As such, its buy and sell signals are often of minimal value for anyone not trading week in and week out. If you can find a charting system which allows longer periods for the stochastic, then it may well turn out to be a much more accurate predictor of long term price movement. As it is right now (set at a 5-day period), signals that are caused by the climbing or dropping out of oversold and overbought regions are only accurate for the next week of trading without any real guarantee as to how far exactly prices will move. I have marked out a 5-day span in the above chart in September as a good example of this over sensitivity of a 5-day stochastic indicator. This oversensitivity also often makes using signal line crossovers of little value when reading the stochastic indicator. (A signal line crossover is when the primary curve crosses either above or below the signal line signalling a buy or sell point, respectively.)

So, if anyone can find me a more customizeable charting program, do let me know and maybe I might revise my opinions of the stochastic oscillator.