Oscillators

Oscillators are among the most valuable tools available to technical analysts, but they are also among the most misunderstood and misused. The trend of a market is the general direction of its price fluctuations-up, down, or sideways. A market's momentum is its rate of acceleration or deceleration. An oscillator is a mathematically derived measure of a market's momentum. As early as the 1920's, technical analysts were creating oscillators to measure a market's momentum rather than limiting their efforts to determining the market's trend.

In any trend, prices are gaining, maintaining, or losing momentum. A loss of momentum in an uptrend or a downtrend-prices rising or falling at a diminishing rate is an early warning sign that the trend might change soon. Therefore, when an oscillator shows that an uptrend is losing momentum, it is a cautionary signal that the uptrend may stall with prices either trading sideways or reversing into a downtrend. Similarly, when an oscillator indicates a loss of momentum in a downtrend, it may foreshadow a potential end to the downtrend.

Stochastic

The stochastic oscillator was developed by George Lane in the late 1950's. Stochastic evaluates a market's momentum by determining the relative position of closing prices within the high-low range of a specified number of days. A 14-day stochastic, for example measures the location of closing prices within the total high-low range of the previous 14 days. Stochastic expresses the relationship between the close and the high-low range as a percentage between zero and 100. A stochastic value of 70 or higher indicates that the close is near the top of the range; a stochastic value of 30 or lower means that the close is near the bottom of the range.

In a robust uptrend, prices generally close near the top of the recent range; in a strong downtrend, prices usually close near the bottom of the range. When an uptrend is approaching a turning point, prices begin to close farther away from the high of the range, and when a downtrend is weakening, prices tend to close farther away from the low of the range. The purpose of the stochastic oscillator is to alert technicians to the failure of bulls to close prices near the highs of an uptrend or the inability of bears to close prices near the lows of a downtrend.

The stochastic is plotted as two lines: %K and %D. The %K and %D formulas produce the fast stochastic oscillator, which is generally considered too sensitive and erratic. Fast stochastic can be subjected to a further three-day smoothing, however, which results in the slow stochastic that most analysts prefer. In the smoothed version of stochastic, the fast %D becomes the slow %K, and a three-day moving average of the fast %D becomes the slow %D.

It is most common to monitor a 14-day slow stochastic, with overbought/oversold levels at 70 and 30, for divergences between prices and the %K or %D lines. When stochastic fails to confirm a market's new high, wait for %K to cross below %D and to drop below 70; when stochastic fails to make a new low along with prices, wait for %K to cross above %D and to climb above 30. After identifying a bullish or bearish stochastic divergence, watch the market's price action for a confirming buy or sell signal. Figure 14 of July '00 wheat shows a recent divergence on the 14 day slow stochastic. This created a sell signal when the stochastic rolled over and crossed. Stops would have been above the swing high.