The first method is to take the average of close prices over a certain period & plot the same on the price chart. This is called moving average.
This period may be any Of The traders requirements. Generally 20,50,100 & 200 day moving averages are calculated.
In this, average ( means addition of close price over taken period divided by number of periods) of close price over a determined period is taken for a day, then for the next day, average is taken excluding the last value & adding previous close, thus period remaining the same. Thus graph is calculated everytime deleting the last value & adding previous close.
Graph thus obtained is plotted on stock price chart & the intersection of both the graph ( stock price & moving average) is used for entry & exit.
The second method is to plot two charts for two different periods for the same stock ( may be 20period & 50 period, 50 period & 100 period) & intersection of these two charts is used for entry & exit.
The demerit of moving averages is that they don't show oversold & overbought conditions as it has no upper or lower boundaries.
Oversold condition -
It indicates price has fallen to much & trend reversal may occur.
Overbought condition -
It indicates price might have reached the end of uptrend & trend may reverse .
There are two types of indicators ,
1.Lagging indicators -
These indicators follow the trend Of The market, whether up or down. Lagging indicators depicts the ongoing trend but unable to predict trend reversal, thus gives less buy & sell signals.
These indicators are useful when big uptrend or downtrend is sustained over a long period.
eg. moving averages, MACD.
2.Leading indicators -
Generally oscillators are treated as leading indicators.
These oscillators oscillates between overbought & oversold conditions ahead Of The price & have ability to predict before the actual trend reversal.
eg. stochastic, relative strength index.
Oscillators measures the velocity of a trend or price move.It does not follow price,hence oscillators are also called momentum indicators. Momentum changes direction before price, hence oscillators have ability to predict the trend.
*Stochastic oscillator -
This theory is developed by George Lane.
The theory depends on the principle that the closing of stock price depends on the particular trend Of The stock. If trend is upward, the prices will close near to the upper end that is high & if the trend is downward the prices will close near to the lower end that is low.
It compares the recent close price with the high & low values over a predetermined period, called look- back period.
The assumption behind the theory is that, stock price closes to the extreme end over a look- back period before trend reversal.
The standard time period to calculate stochastic is 14- period - may be 14 days, 14 weeks, or even 14 months.
Smaller time periods creates false buy & sell signals, still 5-day & 9-day period is followed by many intraday traders.
Now-a-days, there are computer generated software's which creates stochastic chart automatically, but anybody should know the basic .
Basic chart of stochastic oscillator
%k=100*( C - L14/ H14 - L14 )
Where C = Most recent closing price.
L14 = Lowest price traded over previous 14 periods.
H14 = Highest price traded over previous 14 periods.
%k = Value of stochastic oscillator.
Suppose ,today's close price is 120$, the highest price traded over 14 day period is 150$ & the lowest value traded over 14 day period is 100$. By putting these values in the above equation ,we get the answer 40%.
It indicates today's price traded 40% over a 14 period data.
%k is called slow stochastic indicator.
The fast stochastic indicator is calculated by taking simple moving average of previous three periods of %k
%D = k1+ k2 +k3 /3
%D is called the fast stochastic oscillator.
Chart showing %k(fast line)(continuous line)
& %D(slow line)(dotted line)
The value of stochastic 20 or below is treated as oversold condition.
The value of stochastic 80 or above is treated as overbought condition.
These values should not be treated rigid that trend reversal may occur. If a stock is in strong uptrend the stochastic will continue in overbought condition over a period of time.
Similarly, if stock is in strong downtrend the stochastic will continue below 20 over period of time.
In such conditions, other indicators should be taken help to predict the trend.
Convergence & divergence -
Convergence -
When stochastic behaves in unison with stock price,the phenomenon is called convergence.
There are two types of convergences,
a. Bullish convergence -
When in an uptrend, stock price is making higher high's & stochastic is reacting in the same way ( making higher High's) bullish convergence is said to happen.
Bullish convergence(crests in price
chart & stochastic in upward direction)
b. Bearish convergence -
In a downtrend when stock is making lower lows & stochastic is also reflecting the same, making lower low's, it is called bearish convergence.
Bearish convergence (highs of
stock price & stochastic in
downward direction)
It indicates continuation of downtrend.
Divergence -
Divergence occurs when in an uptrend, stock price is making higher high's, or lower low's the stochastic is not in unison with the trend.
There are two types of divergences,
a. Bullish divergence -
In a downtrend, stock price makes lower low's but stochastic makes higher High's or keeping steady.
Bullish divergence (crests in
price chart in downward direction
while crests in stochastic in upward
direction)
b. Bearish divergence -
When in an uptrend ,stock price is making higher high's, but stochastic makes lower low's.
It indicates trend reversal from upward to downward.
How to trade with stochastic -
1. When stochastic is 20 or below, it is a buy signal.
2. When stochastic is 80 or above, it is a sell signal.
3. When %K line intersects %D line from below & proceeds upward, it is a buy signal.
4. When %K line intersects %D line from above & proceeds downward, it is sell signal.
Stochastic is more suitable in trading markets. There are two types of markets, trading & trending.
Trading markets are range bound, oscillates between a certain range of stock price, while trending markets are those in which stock price goes on increasing or decreasing over a long period of time .
If stock is sustaining in overbought or oversold condition, other indicators like MACD should be taken help to judge the ongoing move.
No comments:
Post a Comment