FIN555
Introduction
CHAPTER 8 to Technical
Analysis
01
THE MOMENTUM INDICATOR
(STOCHASTICS OSCILLATOR)
8.1 Introduction
8.2 General Interpretation
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8.1
Introduction
Let’s start our first
set of slides
3
As the trend matures,
the tendency for prices
Introduction to close away from the
high of the session The stochastic indicator,
becomes pronounced. In therefore, attempts to
The stochastic indicator has a downward-moving measure the points in a
also gained a great deal of market, the reverse rising trend at which the
popularity among futures conditions hold true. closing prices tend to
traders, with the result that the cluster around the lows for
standard formula uses very the period in question, and
short-term time spans. The The formula for calculation vice versa, since these are
theory behind the indicator, of %K is: the conditions that signal
which was invented by George trend reversals. It is plotted
Lane,4 is that prices tend to as two lines: the %K line
close near the upper end of a where C is the most recent and the %D line. The %D
trading range during an uptrend. close, L5 is the lowest low line is the one that provides
for the last five trading the major signals and is,
periods, and H5 is the therefore, more important.
highest high for the same
five trading periods.
4
Introduction
Remember that the calculation
of stochastic indicators differs The second line, %D, is a
from that of most other smoothed version of the %K
A very high reading in
momentum indicators in that it line. The normal value is
excess of 80 would
requires high, low, and closing three periods. The %D
put the closing price
data for the calculation. formula is as follows:
for the period near
the top of the range,
while a low reading
The stochastic formula is similar
under 20 would put it
to the RSI in that the plots can
near the bottom of where H3 is the three-period
never exceed 0 or 100, but in
the range. sum of (C – L5) and L3 is the
this case, it measures the
closing price in relation to the three-period sum of (H5-L5).
total price range for a selected
number of periods.
5
Introduction
The momentum indicator The popularity of the
that results from these The behavior of the
stochastic indicator can no
calculations is two lines indicator will depend
doubt be explained by the
that fluctuate between 0 very much on the
smooth manner in which it
and 100. selected time frames.
moves from an overbought
Since the %K and %D
to an oversold condition,
can be thought of as
The %K line is usually lulling a trader into feeling
moving averages, it
plotted as a solid line, that price trends are much
follows that the longer
while the slower %D line more orderly than would
the time span, the
is usually plotted as a appear from an observation
smoother the resultant
dashed line. of an RSI or an ROC
indicator.
indicator.
6
Introduction
The upper panel of Chart 14.21
shows a very volatile 5/5
combination, whereas the lower
window contains a 30/100
combination.
Note that the %K is much less
volatile than that in the upper
window. The same is true for the
100-parameter used in the %D.
However, it is so flat that it is
essentially useless from the point
of view of reflecting the cyclic
rhythms. In reality, one would
never use such a combination.
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8.2
General
Interpretation
Let’s start our
second set of slides
8
General Interpretation
Crossovers Normally, the
Crossovers Normally, the
faster
faster %K line changes
%K line changes
direction
direction sooner than the
sooner than the
%D
%D line. means that
line. This means that
the
the crossover occur
crossover will occur
before
before the
the %D line
line has
has
reversed
reversed direction, as inin
direction, as
Figure
Figure14.2.
14.2.
9
General Interpretation
Divergences Figure
14.3 shows examples of
where the %K fails to
confirm a new high or
low in the price, thereby
setting up a divergence,
which when confirmed,
signals a change in
trend.
10
General Interpretation Divergence Failure An
important indication of a
possible change in
trend arises when the
%K line crosses the %D
line, moves back to test
its extreme level, and
fails to cross the %D
line, as in Figure 14.4.
Once again, it is always
important to see some price
confirmation, and that is
given with the break above
the down trendline in the
right side of the diagram.
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General Interpretation
Reverse Divergence
Occasionally during an
uptrend, the %D line will
make a lower low, which
is associated with a
higher low in the price, as
shown in Figure 14.5.
This is a bearish omen,
and conventional wisdom
suggests looking for a
selling opportunity on the
next rally. This condition
is sometimes referred to
as a bear setup.
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General Interpretation
A positive reverse
divergence is featured
in Figure 14.6.
13
General Interpretation
Extremes Occasionally
the %K value reaches
the extreme of 100 or 0.
This indicates that a very
powerful move is under
way, since the price is
consistently closing near
its high or low. If a
successful test of this
extreme occurs following
a pullback, it is usually an
excellent entry point.
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General Interpretation
Hinge When either the
%K line or the %D line
experiences a slowdown
in velocity, indicated by a
flattening line, the
indication is usually that
a reversal will take place
in the next period.
Examples are shown in
Figure 14.7 and Chart
14.24 in the form of a 10-
minute chart for Pfizer.
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General Interpretation
Hinge When either the
%K line or the %D line
experiences a slowdown
in velocity, indicated by a
flattening line, the
indication is usually that
a reversal will take place
in the next period.
Examples are shown in
Figure 14.7 and Chart
14.24 in the form of a 10-
minute chart for Pfizer.
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Thank you!
Any questions?
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