Pick The Right Settings On Your Stochastic Oscillator (SPY, AAL)

Reviewed by Gordon ScottFact checked by Suzanne KvilhaugReviewed by Gordon ScottFact checked by Suzanne Kvilhaug

The Stochastics oscillator, developed by George Lane in the 1950s, tracks the evolution of buying and selling pressure, identifying cycle turns that alternate power between bulls and bears. Few traders take advantage of this predictive tool because they don’t understand how best to combine specific strategies and holding periods. It’s an easy fix, as you will see in this quick primer on Stochastics settings and interpretation.

Stochastics Construction

The modern or “Full Stochastics” oscillator combines elements of Lane’s “slow stochastics” and “fast stochastics” into three variables that control look back periods and extent of data smoothing.

• Fast K% – measures the closing price compared to specified lookback periods.
• Full K% or K% slows down Fast K% with a Simple Moving Average (SMA).
• Full D% or D% adds a second smoothing average.
• Lower Fast K%, K% and D% variables = a shorter-term lookback period with less smoothing
• Higher Fast K%, K% and D% variables = a longer-term lookback period with greater smoothing

Picking The Best Settings

Choose the most effective variables for your trading style by deciding how much noise you’re willing to accept with the data. Understand that whatever you choose, the more experience you have with the indicator will improve your recognition of reliable signals. Short-term market players tend to choose low settings for all variables because it gives them earlier signals in the highly competitive intraday market environment. Long-term market timers tend to choose high settings for all variables because the highly smoothed output only reacts to major changes in price action.

SPDR S&P 500 Trust (SPY) shows different Stochastics footprints, depending on variables. Cycle turns occur when the fast line crosses the slow line after reaching the overbought or oversold level. The responsive 5-3-3 setting will flip buy and sell cycles frequently, often without the lines reaching overbought or oversold levels. The mid-range 21-7-7 setting will look back at a longer period but keeps smoothing at relatively low levels. However, the setting yields wider swings that generate fewer buy and sell signals. The long-term 21-14-14 setting takes a giant step back, signaling cycle turns rarely and only near key market turning points.

Shorter-term variables elicit earlier signals with higher noise levels, while longer term variables elicit later signals with lower noise levels, except at major market turns when time frames tend to line up, triggering identically-timed signals across major inputs. You can see this happen at the October low, where the blue rectangle highlights bullish crossovers on all three versions of the indicator. These large cycle crossovers tell us that settings are less important at major turning points than our skill in filtering noise levels and reacting to new cycles. From a logistical standpoint, this often means closing out trend-following positions and executing fading strategies that buy pullbacks or sell rallies.

Stochastics and Pattern Analysis

Stochastics don’t have to reach extreme levels to evoke reliable trading strategy signals when the price pattern shows natural barriers. While the most profound turns are expected at overbought or oversold levels, crosses within the center of the panel can be trusted as long as notable support or resistance levels line up. Moving averages, gaps, trendlines, or Fibonacci retracements will often intercede, shortening a cycle’s duration and flipping power to the other side. This highlights the importance of reading the price pattern at the same time you interpret the indicator.

American Airlines Group (AAL) rallied above the 50-day EMA after a volatile decline and settled at new support (1), forcing the indicator to turn higher before reaching the oversold level. It broke out above a 2-month trendline and pulled back (2), triggering a bullish crossover at the midpoint of the panel. The subsequent rally reversed at 44, yielding a pullback that finds support at the 50-day EMA (3), triggering a third bullish turn above the oversold line.

The Bottom Line

Many traders fail to tap into the power of Stochastics because they are confused about getting the right settings for their market strategies. These helpful tips will remedy that fear and help unlock more potential. 

Read the original article on Investopedia.