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The Stochastic Oscillator
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Last week, as part of my "building a trading system" series, we covered the merits of both Technical and Fundamental analysis as they apply to the trading system we are constructing.
This week we'll add another technical indicator and tweak it to suit our system.
What Does it Do for Us?
The Stochastic oscillator is a technical momentum indicator that compares the closing price to the price range over a given period of time. Sensitivity to market movements can be reduced by adjusting the time period or by taking a moving average of the result.The theory behind this indicator is that in an upward-trending market, prices tend to close near their high, and during a downward-trending market, prices tend to close near their low. Buy or sell signals occur when the indicator's lines cross.
The indicator shows buying or selling pressure in the market. The oscillator uncovers extreme readings in prices and warns us of extreme momentum levels as the price action moves through the 20 and 80 levels.
The Most Suitable Market
The Stochastic indicator is best suited to short term trading in range-bound markets, which suits us as day traders.This oscillator is able to isolate tops and bottoms of the price action that correspond with support and resistance levels.
Setting It Up for Our System
The usual "out of the box" settings of the Stochastic indicator are a 14 period calculation for the %K line, which is then plotted against a 3 period average of itself which is the %D line.For our purpose, set it to 7,3,20 which is a 7 period average plotted against a 20 period average of itself. You'll notice we end up with a more responsive %K line plotted against a longer term, more reliable trend line.
Next week, I'll show you the final indicator of our trading system.
Wishing you trading success,
David Stevenson.
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