Saturday, February 14, 2015

The Slow Stochastic and the Dow Industrials

One of the technical indicators that I really like to use when charting stocks is the 14-period Slow Stochastic, developed by George Lane in the 1950s.  The concept behind this indicator is the theory that prices tend to close near their period highs during an upward trending market, and conversely, they tend to close near their lows during a downward trending market.  The Slow Stochastic will oscillate between 0 and 100.  Generally, chartists consider a security to be oversold - potentially giving buy indications - when the value is below 20, and they consider it overbought - potentially giving sell indications - when the value is above 80. 

The indicator provides two values, and thus two lines, on the chart.  The first line, the %K line, charts the closing price of a security as a percentage of its relationship to the high and low of (in my case) the 14-day period of he stock.  The second line, the %D line, is a 3-day Simple Moving Average of the %K line.  There are several ways to interpret the Slow Stochastic, and I tend to use all of them in conjunction with several other indicators and chart patterns.

Please note!  The indicators (like the Slow Stochastic) do not drive stock price.  They are merely tools by which we are able to understand the actions of traders, and therefore assess if those traders are pumping money into a stock or taking money out of a stock.  The indicators tell us something about the sentiment of the traders, not the health of a company.  In using these indicators, we attempt to determine if - based on trader activity - a price is likely to rise or fall over a given time period.  Indicators are a starting point, but not an end in themselves, and no indicator's buy or sell signals alone will replace the due diligence needed on the overall fundamentals of the security you are seeking to trade.

Here are the signals we can interpret from the Slow Stochastic indicator:

%K / %D Crossovers

Visually, these will jump out at you with a quick glance at the chart.  When %K crosses above %D it's a bullish signal, and conversely, when %D crosses above %K it's bearish.  Like most oscillators, though, you can't rely on just this one signal for buy and sell orders.

%K Crosses above 20 or below 80

This is one of my favorite signals since it has a higher tendency to produce winning trades.  When the %K line crosses from below 20 to above 20, it generates a buy signal.  When it crosses from above 80 to below 80, it generates a sell signal.  Now, be careful here.  As a general rule, I will only take signals in the direction of the prevailing trend, and for that I like to use the slope of the 50-day closing price's Moving Average.  If that slope is increasing, I only take buy signals.  If it is decreasing, I only take sell signals.  Note:  Many traders don't wait for %K to cross back above 20 or below 80.  I do, because I've found that it increases the chances of success despite getting you into the trade one or two periods later.

%K Divergence

This doesn't generate buy or sell signals, per se, but it's a very good early warning signal that a trend may be reversing.  A bullish divergence would be indicated if prices for the security are reaching lower lows, but the %K line is reaching higher highs.  It's an indication that price action is about to reverse and warns us to be alert for a good buy signal.  On the other hand, a bearish divergence would be indicated if price is achieving higher highs, yet the %K line is dropping to lower lows.  It's a warning that a bullish trend may be exhausted and a decline in price is imminent.  In this case, we watch for a good sell signal to either close a position or to open a short position.

So what does all this have to do with the Dow Industrials? Well, let's take a look at both the daily and the weekly charts for the Dow.

Dow Industrials Daily Chart

Look at the time period starting around October 27th.  Closing prices for the Dow were on a very steady upward slope.  The Slow Stochastic, however, was on a downward slope in overbought - above 80 - territory.  The warning signs should be blaring since that's a classic bearish divergence.  Sure enough, the second week of December, the market took a nose dive.  Did you notice that, just before it dove, we had a bearish %K/%D crossover?  You can see the red line - %D - crossing above %K just as the price started to plummet.  That's warning sign number 2.  The final warning came when %K crossed below 80 and, well, you can see what the price action did after that.

So where are we are right now?  The Slow Stochastic is solidly in overbought territory.  %K is above %D and still trending up, but since this is a bound indicator, we know that can't continue much longer.  We don't have any divergence yet, though, so other than being in overbought territory there's nothing else in the Stochastic that would have us concerned.  (A glance at the actual chart also looks pretty good, although we're trading in the upper 20% of the Bollinger Band which is where I start looking for sell indicators.)

But now let's take a look at the Weekly Chart:

Dow Industrials Weekly Chart

As I've noted in the past, the Dow's been trading in a very nice upward channel, bound by the blue resistance line you see on the chart and the 50-period moving average (in red) as support. Let's look at the Slow Stochastic using the 14-period indicator.  The recent down weeks in the market pulled the indicator out of overbought territory and you can see the subsequent (temporary) drop in price.  (Remember, the slope of the 50-period moving average is up, so I'd ignore any sell signals here.  Tighten stops, or wait for a good long entry, but there's no way I'd go short on any security showing that strong an upward slope.)  The Dow bounced very nicely off support again, and we have a very nice bullish crossover following the close at the end of this week.  Looking at the lows of the Stochastic, they are forming a nice upward trend line as well, matching the price action of the lows, so there's no divergence, either.

The only warning signs on this chart, in fact, is that we are approaching the resistance line once again, and we're trading in the upper 10% of the Bollinger Band.  Whether or not we bounce off resistance and head back down or whether we break through resistance and surge upward will depend on the geopolitical situation as well as the economic indicators released in the coming weeks.  Earnings season is essentially over until late March and April, so we won't have earnings announcements pushing the market for the next couple of months.

One last item to note, though, is about the use of any indicator to analyze a market index.  Remember that the index - in this case the Dow - is based on the price action of the stocks that comprise that index.  In today's age of computerized trading, however, the technical analysis of the index itself is used by traders to gauge whether or not they should take some profits in the stocks that comprise the index or whether or not to enter new positions within that index.  Never forget that it's the price action of the underlying securities that drives the index - and thus drive the indicators that we use to analyze that index. 

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