Technical Stock-Picking: How to Trade Off of Stochastic Oscillators

This technical analysis-based assignment was written Stockpickr member Ira Krakow.

Stock market technicians use Stochastic oscillators to measure a stock's momentum -- the strength of a move in a particular direction. But looking at a chart's trend is not enough to make a trade decision.

If an uptrend's strength is weak, it could easily reverse quickly and you could end up buying just before the price tanks. Or if you're unable to spot a healthy trend, you could miss out on a big upside move. Interpreting a stochastic chart correctly can help you avoid these problems.

A Stochastic Look at Hovnanian

With its roots in the Greek language, the word stochastic means to "to guess" or "to aim." The term's application in the stock world is to come up with a percentage -- 0% for totally impossible to 100% for totally certain -- that a trend will continue.

Stochastics come in two flavors: fast and slow. Fast stochastics produce more buy and signals than slow stochastics, but some of the signals produced by fast Stochastics may be "false." Slow Stochastics produce fewer, but "stronger" signals.

The stochastic is an "oscillator" because it fluctuates up and down, in a wavelike manner, generating potential buy and sell signals. As an example, look at a three-month chart (from Yahoo! Finance Charts, for the period ending March 10, 2008) of homebuilder Hovnanian Enterprises (HOV Quote), with its fast Stochastic and slow Stochastic indicators:

Click here for larger image.

At its core, the stochastic formula is based on the idea that if a stock closes near its high, its trend is upward, and if a stock closes near its low, the trend is downward.

How to Read a Stochastic Chart

There are two common ways to interpret these waves. The first is based on when the red and blue lines cross. A potential buy signal is generated when the blue line crosses above the red line, and a potential sell signal is generated when the red line crosses above the blue line.

The second way to translate these charts is based on a reading of the blue line (%K). When %K is at 20 or below, the stock is considered to be oversold . When %K goes above 20, the stock should be bought. On the other hand, when %K is at 80 or above, the stock is considered to be overbought , and when %K goes below 80, the stock should be sold.

To learn how to create stochastic charts on your own, check out the step-by-step appendix at the end of this assignment.

Timing Buy and Sell Points

Hovnanian's stock fluctuated wildly, from $5 to $12, during these three months. If you could time your buys and sells correctly, you could have made hefty profits. If you used the fast Stochastics, you would have made more trades based on the signals, but on a number of them, you would have bought or sold on an extremely short term "false" signal. A better strategy would have been to use the Slow Stochastics. Here's the same chart of Hovnanian, showing the potential buy and sell points, using Slow Stochastics.

Click here for larger image.

Here, you would have bought in early January, when %K was below 20 and trending higher and the red line crossed below the blue line, and sold in early February, when %K was above 80 and trending lower and the red line crossed above the blue line.

By buying in early January and selling in late February, and ignoring the other crossover points because they didn't satisfy both criteria, you would have captured the most profitable move in the shortest time period.

Your Stochastic Assignment

To put these indicators to work, let's check out the homebuilder stocks. They are still fluctuating wildly, because of actions by the Fed and housing supply and demand. But could money be made in timing buys and sells? Let's find out.

Step 1. On Stockpickr, create a portfolio called "Stochastic Trades: [Your Stockpickr Username]". (To create a portfolio on Stockpickr, you'll need to first log in. If you're currently not a Stockpickr member, you can register at www.stockpickr.com/register.)

Step 2. For research purposes, in addition to Hovnanian, add the following stocks: D.R. Horton (DHI Quote), Centex Corporation (CTX Quote), Lennar Corporation (LEN Quote), Pulte Homes (PHM Quote), Ryland Group (RYL Quote), Toll Brothers (TOL Quote) and KB Homes (KBH Quote).

Step 3. Using your favorite charting software, such as Yahoo! Finance Charts, plot a three-month OHLC (Open, High, Low, Close) chart with the Slow Stochastics (the chart similar to our chart for Hovnanian) for each home builder.

On your Stockpickr portfolio, document the day and price that the Slow Stochastics indicator produced a potential buy or a sell signal each stock's "Reason?" box.

Do all of them exhibit the same buy and sell signals as Hovnanian, or did they act differently?

Step 4. With the same chart settings, plot a five-day chart, documenting the day and price that the Slow Stochastics indicator produced a buy or a sell signal in the "Reason?" box.

Are the buy and sell signals the same for all companies? Step 5. Select the three best stocks for a trade. Using an intraday chart with five-minute candle intervals (see "Technical Stock-Picking: Candle Charts Can Light Your Way"), pick the best time to buy. Document the price and time in the "Reason?" box.

Step 6. Follow these three stocks each day for the next three trading days. Use the Stochastics to pick the best time to sell.

Were you able to time your sale for maximum profit?

Please note: As with other technical indicators, it's difficult to use stochastics to precisely time buys and sells. Unanticipated events can, and will, cause even the most extensively researched technical analysis to fall short.

So experiment with different chart time frames and indicators until you have reasonable confidence in your buy and sell decisions.

Appendix: How to Generate Stochastic Charts on Yahoo! Finance Charts

Follow these steps:

1. On the standard quote page, click "Basic Tech. Analysis" on the left side of the screen.

2. In the "Indicators" section, to view the Slow Stochastics, click "Slow Stoch." To view the Fast Stochastics, click "Fast Stoch."

3. You can then modify the view via the "Range" links and add other technical graphs like "Type," "Moving Avg," and "Overlays."