Saeed Ebrahimijam Spring 2013

DoğuAkdenizÜniversitesi Faculty of Business and Economics Department of Banking and Finance Fundamentals of Technical Analysis and Algorithmic Trading Chapter 17: Stochastic Indicator (%K) SaeedEbrahimijam Spring 2013 FINA417

Contents • Stochastics Indicator Theory • Stochastics Indicator Calculations • %K DIVERGENCE ANALYSIS • %K EXTREME READINGS Fundamental of Technical Analysis and Algorithmic Trading

Introduction • The stochastics approach to market analysis was developed by George C. Lane (Investment Educators). • It has become very popular among investors, especially those who are short-term oriented (although it is equally effective for longer investment horizons). Fundamental of Technical Analysis and Algorithmic Trading

Stochastics Indicator Theory • Stochastics is a price velocity technique based on the theory that, “as prices increase, closing prices have a tendency to be ever nearer to the highs for the period.“ • Similarly, as prices move lower, closing prices tend to be closer and closer to the lows for the period. Fundamental of Technical Analysis and Algorithmic Trading

CALCULATION • The formula for calculating stochastics is as follows: • %K is then smoothed, typically using a three-period simple moving average, to derive %D. Fundamental of Technical Analysis and Algorithmic Trading

The resulting %K and %D lines when plotted show, on a percentage basis of 0 to 100, where the closing price is relative to the range of prices for a given period of time (i.e., five days). Fundamental of Technical Analysis and Algorithmic Trading

Fundamental of Technical Analysis and Algorithmic Trading

DIVERGENCE ANALYSIS • The principal method of interpreting stochastics for buy and sell signals is through divergence analysis. • A bearish divergence occurs when a security’s price makes a high, then corrects moving lower, and subsequently reaches a higher high. • At the same time, corresponding peaks of the %D line make a high followed by a lower high. • Confirmation and the signal to sell occur when the %K line moves below the %D line. (see Figure 16-2) Fundamental of Technical Analysis and Algorithmic Trading

DIVERGENCE ANALYSIS • A bullish divergence occurs when a security’s price makes a low, then corrects moving higher, and subsequently reaches a lower low. • At the same time, corresponding bottoms of the %D line make a low followed by a higher low. • Confirmation and the signal to buy comes when the %K line moves above the %D line. (see Figure 16-3) Fundamental of Technical Analysis and Algorithmic Trading

Stochastics Indicators Trading signal Fundamental of Technical Analysis and Algorithmic Trading

EXTREME READINGS • It is not unusual for the %K line to reach 0 or 100 percent. Such readings do not mean that the price of a particular security has reached a bottom (0 percent) or top (100 percent). They do suggest great weakness (0 percent) or strength (100 percent). • When a reading of 0 percent is reached, the %K line frequently moves up to the 20–25 percent level and then declines again to or near the 0 percent level. When %K moves up from that area, one can expect a minor rally in prices to occur. • The opposite holds true for 100 percent readings. After reaching 100 percent, the %K line often will drop to the 75–80 percent range and then move back up to or near the 100 percent level. On the %K line’s next decline, a minor reaction (drop in prices) is likely. Fundamental of Technical Analysis and Algorithmic Trading

REVERSAL WARNING SIGNAL • When the %K line has been moving in one direction for many periods and suddenly one period reverses direction sharply (for 2 to 12 percent), a warning signal is given. Prices are likely to reverse direction in one or two periods. Fundamental of Technical Analysis and Algorithmic Trading

Be aware of failed signals!!! Fundamental of Technical Analysis and Algorithmic Trading

Saeed Ebrahimijam Spring 2013