We've spent the last few days exploring indicators in great detail. Along the way
we've mentioned that stochastics has been a fairly effective tool, so today I'd like
to focus on a couple of the nuances unique to the stochastic oscillator. We chose to
do this today since most of the major indices are quickly approaching this situation.
First, let's briefly explain the concept of stochastics. Essentially, stochastic
lines are plotted based on what price a stock is trading at now in relation to its
recent trading range. The premise is that a stock can only move up or down a certain
amount in a given period of time. If it climbs or falls at a rapid pace, there's a
high likelihood it has traveled to far too fast, and is a good candidate for a
reversal. When it appreciates very quickly, it's often said to be 'overbought', and
stochastics would give a 'sell' signal. On the flip side, if it falls rapidly, it may
become 'oversold'. This would generate a 'buy' signal, since its decline has likely
been exhausted, leaving it nowhere to go but up.
Stochastics, then, is designed to graphically indicate these points where stocks are
overbought or oversold. This is going to be an important today and tomorrow, as we
are starting to see plenty of stochastic charts (depending on your stochastic
settings) enter the 'oversold' region. This is not surprising since we've had some
strong declines recently. Why is this such a critical issue today? Because even
though we're entering the 'oversold' area on the chart, this is not necessarily a
'buy' signal. We're still in a major downtrend, and we saw only a few weeks ago that
entering the 'oversold' area doesn't guarantee a reversal. We may stay oversold (and
continue the decline) for quite some time, as we did in January and February.
The real signal is the point when the stochastic lines leave the oversold region by
crossing back above the oversold threshold line. This is an indication that there is
at least a little upward momentum. Even then, stochastics may not be your best tool
right now. We got an errant stochastic 'buy' signal in mid-February that came right
as the market started a severe decline (although it did signal accurately in late
December).
DOW WITH SLOW STOCHASTICS - DAILY
That's one of the quirks with stochastics - it doesn't really handle the ultra-short
volatility very well, as you saw in mid-February. Plus, being 'oversold' doesn't
always mean a reversal is imminent. When the downtrend is strong (like now), we can
stay oversold for a while. I caution against using stochastics as your only signal
right now. The bearish momentum is still pushing the market lower, no matter what
stochastics say.
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