Choose the correct setting on your stochastic oscillator (SPY, AAL)

The Stochastic Oscillator developed by George Lane in the 1950s tracks the evolution of buying and selling pressures and identifies the cyclical turn between longs and shorts. Few traders use this forecasting tool because they do not understand how to best combine specific strategies and holding periods. This is a simple solution, as you will see in the quickstart on stochastic indicator setup and explanation.

Stochastic modeling definition

Random construction

The modern or “complete stochastic” oscillator combines the elements of Lane’s “slow stochastic” and “fast stochastic” into three variables to control the lookback period and the degree of data smoothness.

  • Fast K%-measures the closing price compared to the specified lookback period.
  • Full K% or K% uses simple moving average (SMA) to slow down fast K%.
  • The complete D% or D% adds a second smoothed average.
  • Lower fast K%, K%, and D% variables = shorter lookback period with lower smoothness
  • Higher fast K%, K% and D% variables = longer lookback period with greater smoothness

Choose the best setting

By deciding how much data noise you are willing to accept, choose the most effective variable for your trading style. Understand that no matter what you choose, the more you experience with indicators, the better your recognition of reliable signals. Short-term market participants tend to choose low settings for all variables, as this provides them with an earlier signal in the highly competitive intraday market environment. Long-term market timers tend to choose high settings for all variables, because the highly smooth output only reacts to major changes in price behavior.

SPDR S&P 500 Trust (SPY) displays different stochastic indicators, depending on the variable. When the fast line crosses the slow line after reaching an overbought or oversold level, a cyclical turn occurs. Responsive 5,3,3 settings often flip the buying and selling cycle, and usually do not reach overbought or oversold levels. The mid-range 21,7,7 settings look back for a longer period of time, but remain smooth at a relatively low level, resulting in wider volatility and fewer buy and sell signals. The long-term 21, 14, and 14 settings have taken a big step back, indicating that the cycle rarely turns, and only near key market turning points.

Short-term variables elicit earlier signals with higher noise levels, and longer-term variables elicit later signals with lower noise levels, unless the time frame tends to be consistent when the major market turns, thereby triggering the same in the main input The signal of time. You can see this at the October low, with the blue rectangle highlighting the bullish intersection of all three versions of the indicator. These big loop intersections tell us that at the main turning point, settings are not as important as our skills in filtering noise levels and reacting to new loops. From a logistical point of view, this usually means closing trend-following positions and implementing a decay strategy of buying pullbacks or selling rebounds.

Random and pattern analysis

Stochastic indicators do not have to reach extreme levels to evoke reliable signals, especially when price patterns show natural obstacles. Although the most profound shift is expected at overbought or oversold levels, as long as significant support or resistance levels are arranged, the intersection at the center of the panel can be trusted. Moving averages, gaps, trend lines or Fibonacci retracements usually intervene to shorten the duration of the cycle and turn the power to the other side. This highlights the importance of reading price patterns while interpreting indicators.

American Airlines Group (AAL) rebounded above the 50-day moving average after a shock drop and closed at a new support level (1), forcing the indicator to turn higher before reaching oversold levels. It broke the 2-month trend line and fell back (2), triggering a bullish crossover at the midpoint of the panel. The subsequent rally reversed at 44, producing a callback and found support at the 50-day moving average (3), triggering a third bullish turn above the oversold line.

Bottom line

Many traders fail to use the power of stochastic indicators because they are confused about getting the correct settings for their market strategy. These useful techniques will eliminate this fear and help unleash more potential.


READ ALSO:   Buying weakness
Share your love