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 (sto kas'tik) adj. 2. Math. designating a process having an infinite
progression of jointly distributed random variables.
--- Webster's New World Dictionary
The Stochastic Oscillator compares where a security's price closed relative to its
price range over a given time period.



The Stochastic Oscillator is displayed as two lines. The main line is called "%K."
The second line, called "%D," is a moving average of %K. The %K line is usually
displayed as a solid line and the %D line is usually displayed as a dotted line.
There are several ways to interpret a Stochastic Oscillator. Three popular
methods include:
Buy when the Oscillator (either %K or %D) falls below a specific level
(e.g., 20) and then rises above that level. Sell when the Oscillator rises
above a specific level (e.g., 80) and then falls below that level.
1.
Buy when the %K line rises above the %D line and sell when the %K line
falls below the %D line.
2.
Look for divergences. For example, where prices are making a series of
new highs and the Stochastic Oscillator is failing to surpass its previous
highs.
3.


The following chart shows Avon Products and its 10-day Stochastic.
I drew "buy" arrows when the %K line fell below, and then rose above, the level
of 20. Similarly, I drew "sell" arrows when the %K line rose above, and then fell
below, the level of 80.
This next chart also shows Avon Products.
In this example I drew "buy" arrows each time the %K line rose above the %D
(dotted). Similarly, "sell" arrows were drawn when the %K line fell below the %D
line.
This final chart shows a divergence between the Stochastic Oscillator and prices.
This is a classic divergence where prices are headed higher, but the underlying
indicator (the Stochastic Oscillator) is moving lower. When a divergence occurs
between an indicator and prices, the indicator typically provides the clue as to
where prices will head.

The Stochastic Oscillator has four variables:


This is the number of time periods used in the stochastic calculation.
1.
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This value controls the internal smoothing of %K. A value of 1 is
considered a fast stochastic; a value of 3 is considered a slow stochastic.
2.
 

This is the number of time periods used when calculating a moving
average of %K. The moving average is called "%D" and is usually
displayed as a dotted line on top of %K.
3.
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The method (i.e., Exponential, Simple, Time Series, Triangular, Variable,
or Weighted) that is used to calculate %D.
4.
The formula for %K is:
For example, to calculate a 10-day %K, first find the security's highest-high and
lowest-low over the last 10 days. As an example, let's assume that during the last
10 days the highest-high was 46 and the lowest-low was 38--a range of 8 points.
If today's closing price was 41, %K would be calculated as:
The 37.5% in this example shows that today's close was at the level of 37.5%
relative to the security's trading range over the last 10 days. If today's close was
42, the Stochastic Oscillator would be 50%. This would mean that that the
security closed today at 50%, or the mid-point, of its 10-day trading range.
The above example used a %K Slowing Period of 1-day (no slowing). If you use
a value greater than one, you average the highest-high and the lowest-low over
the number of %K Slowing Periods before performing the division.
A moving average of %K is then calculated using the number of time periods
specified in the %D Periods. This moving average is called %D.
The Stochastic Oscillator always ranges between 0% and 100%. A reading of 0%
shows that the security's close was the lowest price that the security has traded
during the preceding x-time periods. A reading of 100% shows that the security's
close was the highest price that the security has traded during the preceding
x-time periods.

 #c $% $ &

 

The Relative Strength Index ("RSI") is a popular oscillator. It was first introduced
by Welles Wilder in an article in Ê

(now known as  
) Magazine
in June, 1978. Step-by-step instructions on calculating and interpreting the RSI
are also provided in Mr. Wilder's book, New Concepts in Technical Trading
Systems.
The name "Relative Strength Index" is slightly misleading as the RSI does not
compare the relative strength of two securities, but rather the internal strength of
a single security. A more appropriate name might be "Internal Strength Index."
Relative strength charts that compare two market indices, which are often
referred to as Comparative Relative Strength.



When Wilder introduced the RSI, he recommended using a 14-day RSI. Since
then, the 9-day and 25-day RSIs have also gained popularity. Because you can
vary the number of time periods in the RSI calculation, I suggest that you
experiment to find the period that works best for you. (The fewer days used to
calculate the RSI, the more volatile the indicator.)
The RSI is a price-following oscillator that ranges between 0 and 100. A popular
method of analyzing the RSI is to look for a divergence in which the security is
making a new high, but the RSI is failing to surpass its previous high. This
divergence is an indication of an impending reversal. When the RSI then turns
down and falls below its most recent trough, it is said to have completed a "failure
swing." The failure swing is considered a confirmation of the impending reversal.
In Mr. Wilder's book, he discusses five uses of the RSI in analyzing commodity
charts. These methods can be applied to other security types as well.
'
The RSI usually tops above 70 and bottoms below 30. It usually forms
these tops and bottoms before the underlying price chart.
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The RSI often forms chart patterns such as head and shoulders (page
215) or triangles (page 216) that may or may not be visible on the price
chart.
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(also known as support or resistance penetrations or breakouts). This is
where the RSI surpasses a previous high (peak) or falls below a recent
low (trough).
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The RSI shows, sometimes more clearly than price themselves, levels of
support and resistance.
l





As discussed above, divergences occur when the price makes a new high
(or low) that is not confirmed by a new high (or low) in the RSI. Prices
usually correct and move in the direction of the RSI.
l
For additional information on the RSI, refer to Mr. Wilder's book.


The following chart shows PepsiCo and its 14-day RSI.
A bullish divergence occurred during May and June as prices were falling while
the RSI was rising. Prices subsequently corrected and trended upward.





A divergence occurs when the trend of a security's price doesn't agree with the
trend of an indicator. Many of the examples in subsequent chapters (see page )
demonstrate divergences.
The chart in Figure 34 shows a divergence between Whirlpool and its 14-day CCI
(Commodity Channel Index). [See page .] Whirlpool's prices were making new
highs while the CCI was failing to make new highs. When divergences occur,
prices usually change direction to confirm the trend of the indicator as shown in
Figure 34. This occurs because indicators are better at gauging price trends than
the prices themselves.

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