Screening to Win: Fast and Slow Stochastic

This is the third installment in the series "Screening to Win". This article discusses utilizing the Stochastics technical indicator in your screening. The earlier commentary about Moving Averages and RSI can be found at:
Moving Averages
http://hingefire.blogspot.com/2007/11/screening-to-win-moving-averages.html
RSI
http://hingefire.blogspot.com/2007/11/screening-to-win-rsi-relative-strength.html

The overview below describes one of the common technical indicators – Stochastics and provides insights on how to utilize it in your stock selection. Hopefully this outline will provide traditional fundamental investors with some solid insight on how to incorporate technical indicators into their screening. The free HingeFire Stock Screener which can be found at http://www.hingefire.com is one of the few tools available that includes a wide selection of fundamental and technical criteria for selecting stocks. Using a combination of fundamental and technical screening is a powerful tool for winning in the market.

Slow and Fast Stochastic

Slow and Fast Stochastic Overview

The Stochastic indicator was originally developed by George C. Lane in the late 1950s and has gained wide-spread popularity since this time. The Stochastic indicator is a momentum oscillator that reveals the location of the current close relative to the high-low price range over a defined number of periods. Generally, levels that are near the top of the range indicate accumulation and those near the bottom of the range indicate distribution.

Stochastic oscillators normally utilize a 14 day formation period and a three day smoothing filter. The indicator is presented as a percentage running from 0 to 100. Stochastic indicators normally have two sub-components; %K line which is the unsmoothed relationship of the price to the highs and lows over a 14 day period, and %D line which applies a 3 days smoothing filter to this data.

There are two common stochastic oscillators; fast and slow. The fast stochastic oscillator adjusts more quickly then the slow stochastic. This is understandable because the slow stochastic indicator is normally created by applying an additional 3 day filter to the %D information associated with the faster indicator. As expected, the fast stochastic oscillator is more prone to whip-saws and quicker movement then its slower cousin.

The HingeFire stock screening tool provides support for both Slow and Fast Stochastic indicators. Support for the 20 (oversold) and 80 (overbought) levels is incorporated. Users can scan to determine if the stochastic reading is greater than or less than a particular level, and also establish if the fast or slow stochastic just crossed above (JCA) or below (JCB) these thresholds.

How to use Stochastics in screening

Most investors utilize stochastics to identify oversold and overbought conditions. Stochastic levels below 20 are generally considered oversold and above 80 are considered overbought. However a reading below 20 is not necessarily bullish, nor a reading above 80 bearish. Stochastic indicators can remain at these levels for lengthy periods of time. It is more important to focus on situations where the stochastic crosses below 80 indicating an exit from an overbought condition, or crosses above 20 indicating an egress from an oversold condition.

Both the %K and %D for stochastic indicators are normally displayed on charts. The recent chart of 3M Corp (MMM) shows an example of a slow stochastic that recently just crossed above (JCA) the 20 level. This is one of the stocks recently found using the HingeFire tool to screen for stocks whose slow stochastic just crossed above this level. Normally this is taken as a sign that the selling pressure is exhausted and the stock price is poised to rise.

As a point of interest notice the earlier price drops in the 3M chart that occurred when the slow stochastic level fell below 80. The drop below 80 indicates an exhaustion in buying and commonly leads to either a brief retrenchment or more significant drop in price

A fairly volatile stock Amerco (UHAL) recently had its fast stochastic just cross below (JCB) the 80 level. This cross below was followed by a price drop of more then $8 for the stock. Many traders utilize fast stochastic to get in on moves early.

Note the lag of the slow stochastic as compared to the fast stochastic for the volatile stock in the diagram above (both are plotted). A trader using the fast stochastic would have caught the recent move down near the peak; while an investor using the slow stochastic would have gotten in on this move much later. This is a solid demonstration of the difference between the two indicators; note that the slow stochastic is still a very reliable indicator for timing buys and sells for long term investors focused on non-volatile instruments.

It is generally deemed that investors should use a fast stochastic for the timing of medium term trades with volatile stocks. The slow stochastic is more useful to determine entries and exits for longer term investments, or if you find that the fast stochastic causes you to over-trade.

There is one school of thought that states that investors should look at charts and focus on the divergence between price and stochastic level near oversold and overbought levels. Many times the second time that the stochastic indicator crosses out of an overbought or oversold condition in a short period of time is deemed a better indication of final exhaustion in buying or selling.

In summary, many investors use the HingeFire tool to screen for the following situations with Stochastics.

• Break Above Oversold with Slow Stochastic – Screening for stocks that JCA the 20 level as entry points for long term investments on non-volatile stocks.
• Break Below Overbought with Slow Stochastic – Screening for stocks that JCB the 80 level as exit points for long term investments on non-volatile stocks, or possibly to short.
• Break Above Oversold with Fast Stochastic – Screening for stocks that JCA the 20 level as a long entry points for trades on more volatile stocks.
• Break Below Overbought with Fast Stochastic – Screening for stocks that JCB the 80 level as an entry point to get short.

Combining technical indicators such as Stochastics with commonly used fundamental criteria when selecting your investments helps put the market edge in your corner. The support for Slow and Fast Stochastic indicators in the HingeFire Stock Screener adds a powerful tool for timing your transactions.