A N A LY S I S T O O L S

By Ng Ee Hwa, ChartNexus Market Strategist

TRADING STRATEGIES
USING STOCHASTIC

In the aftermath of the global market correction following the big drop in the Chinese stock market
indices in Feb 2007, investors have returned to the markets with a vengeance pushing the indices to scale
new heights almost daily. However with recent moves by the Chinese authorities to cool the bullishness
through measures such as the increase in stamp duties, the Chinese stock markets have again dropped
significantly in the first few days of June 2007. This example of wild swings in the market sentiment can
cause serious damage to the retail investor’s pocket, especially those uneducated in the forces at play in
the stock market. Consequently it is vital that investors and traders are well-equipped in technical analysis
tools to time the market effectively. This article will look at one of the tools in Technical Analysis indicators
called Stochastic, a momentum indicator that shows clear bullish and bearish signals.

Stochastic is a momentum oscillator oscillators that oscillate in a fixed range, an

developed by George C.Lane in the late 1950s. overbought and oversold condition can be
Lane noticed that in an up trending stock, prices specified. Based on his trading experience, Lane
will usually make higher highs and the daily closing defined the overbought and oversold region for
price will tend to accumulate near the extreme the Stochastic value to be above 80 and below
highs of the “look back” periods. Similarly, a down 20 respectively. He deemed that a Stochastic value
trending stock demonstrated the same behavior above 80 or below 20 may signal that a price trend
of which the daily closing price tends to reversal may be imminent.
accumulate near the extreme lows of the past
Stochastic is made up of 2 main components,
periods. Thus Lane used a mathematical formula
the %K line and the %D line. The %K line whose
to calculate the Stochastic whose value decreases
value ranges from 0 to 100 is calculated based on
toward 0 in a down market and increases toward
the high of recent closing price with respect to the
100 in an up market. Furthermore as with most

40 PULSES JUN 2007

highest and lowest price attained during the that Stochastic can be used to find meaningful
specified period. The value of %D is derived from signals.
taking the moving average of %K (where the period
The most basic usage of Stochastic is in the
of the moving average is commonly set at 3 days).
Crossovers theories. A buy/sell signal is generated
This is also known as the fast Stochastic, %K (fast)
when %K line crosses up/down %D line
and %D (fast). However, the fast Stochastic’s
respectively. However the crossover signals
reaction to the price action causes many frequent
proved to be quite unreliable as their occurrences
signals which then lead to the creation of many
are quite frequent. A more reliable usage of
false buy/sell signals. Hence, in order to render
Stochastic is in the divergence analysis. Notice
the signals more efficient, the slow Stochastic was
that when a price is making a higher high, the
developed. The %K (slow) line is the same as the
indicator should also be making a higher high while
%D (fast) line whilst the %D (slow) line is the 3
a lower low in price should be accompanied by a
days moving average of %K (slow) line. This is
lower low in the indicator. However in scenarios
termed as the Full Stochastic Oscillator (Full STO)
where the price makes a higher high and the
which consist of the %D (fast), %D (slow) and %K
indicator fails to make a higher high or when the
(full) and its uniqueness is the usage of “smoothing
price makes a lower low and the indicator fails to
factor” for the initial %K line to plot the %K (full)
make a lower low, a divergence is said to have
line. While it is important to know how an indicator
taken place, the former being termed a bearish
is built, this article will focus on the different ways
divergence and the latter a bullish divergence.

Figure 1:
Bullish/Bearish
Divergences in
Oversold/
Overbought region

Figure 2:
Usage of Stochastic
with the GMMA
indicator

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 from pg 41

Stochastic bullish/bearish divergence is the Guppy

Figure 3: Use of Stochastic with Trendline Analysis Multiple Moving Average (GMMA) which was
developed by Daryl Guppy. GMMA is a powerful
indicator used to understand the nature and
character of the trend and it is made up of two
sets of exponential moving average (EMA) lines -
the shorter-term EMA and the longer-term EMA.
The shorter-term EMA are made up of
3,5,8,10,12,15 days EMA lines and the longer-
term EMA are made up of 30,35,40,45,50,60 days
EMA lines. Let us re-visit the earlier chart (Figure
1) which illustrated the bullish divergence in
October 2006. An analysis of the GMMA in Figure
2 shows that a crossing up of the shorter-term
EMA lines over the longer-term EMA took place
around the 16th October 2006 thereby confirming
the bullish signal generated by the Stochastic
bullish divergence.
Instead of using another indicator to confirm
the Stochastic signal, we may use trendline
analysis to do that. Figure 3 illustrates the usage
of trendline analysis to confirm the bearish
divergence in Stochastic. The blue uptrend line
supported the increase in price from $1.27 to
During the period of late September 2006 to $1.80 in the period of March 2007 to early May
mid October 2006, Noble’s stock price was in a 2007. However the price broke down the uptrend
down trend. However, Stochastic formed a bullish line in late April 2007 and failed in its attempt to
divergence and near mid October 2006, a short- move back up on 7th May 2007. Coupled with
term trend reversal took place. the bearish divergence in Stochastic, this gave a
On the other hand, during the period of March strong indication of an impending trend reversal.
2007 to May 2007, the price engaged in a bullish This article has highlighted the importance of
run but Stochastic showed sign of weakness by having a clear timing strategy when trading the
failing to make higher highs with higher highs in stock market. A powerful indicator in technical
price. A bearish divergence occurred and soon analysis is Stochastic, a momentum indicator best
afterward a downtrend followed. used to identify bullish and bearish divergences
We can enhance the quality of the Stochastic which are signals that warn of an impending trend
divergence signal with another indicator to increase reversal. To increase the reliability of divergence
the probability of making a winning trade. A popular signals, a different indicator or trendline analysis
indicator that can be used together with the may be used. ■

STRATEGIES USING CHART FORMATIONS

Chart formations such as Double Bottom, Cup & Handle, Head & Shoulder, Double
Top give powerful bullish and bearish signals. Combining this field of TA with technical
indicators greatly increases the probability of the trading signals being right.
Sign up for this seminar where chart formations and the market psychology behind
them will be introduced.
Date : 19 July 2007 (Thursday)
Time : 7:00pm – 9:00pm
Venue : SGX Auditorium, Level 2, SGX Centre 1,
2 Shenton Way, Singapore 068804 (Next to Lau Pa Sat)
Course fee : S$20
A dinner reception will be held for all the participants. To register or to find out more
information about this event, please visit http://www.chartnexus.com/events
or contact us at (65) 64911453 / 64911454

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