Stochastic: Oscillate the Right Way – A study of SBIDeveloped by George Lane in 1950 – Stochastic (SO) is a momentum oscillator, that is, it follows the momentum of price. Its value oscillates between 0 to 100.
The general interpretation of SO is that stock is overbought when SO value is above 80 and oversold below 20. But to what extent this interpretation is correct? Let’s find out.
I am taking State Bank's weekly chart (random pick) 2013 onwards. Although the study is applicable to all time frames yet it is more reliable on larger timeframes. The smaller timeframes can always be used for better entries and exits.
I am taking only %D line which is 3 period MA of %K (not showing here on SO chart) which represents the current value of SO. The reason for choosing %D is that it is smooth and less noisy. A cross of %K over %D is used as buy and sell signals. But a lot of false signals are generated through this system as it noisy in case of volatile stocks, so I am ignoring this system in this study.
Overbought Zones and Rallies
Let’s first concentrate on points where SO cross above 80
Point C: Stock rallied 57%
Point E: Stock rallied 20%
Point I: Stock rallied 29%
Point K: Stock rallied 7%
Oversold Zones and Falls
Now concentrate on points where SO value crossed below 20
Point a: Stock fell -25%
Point c: Stock fell -9%
Points e,f: Stock almost flat
Point g: Stock fell -11%
Point h: Stock fell -33%
So is it a good practice to sell a stock because SO is above 80? Absolutely not, rather when SO value crosses 80 a buy should be triggered because stock is in bullish momentum. Same is true for SO cross below 20, it generates sell signal.
Divergence and Price oscillation: Another Interpretation
Another interpretation of SO is through Divergence. Means when price is making higher peaks but SO is making lower peaks or stock making lower troughs and SO making higher troughs.
Between points b and d: huge divergence on SO, Price flat at D1; rally 93%
At F: Divergence with rising price (D2); initial fall 23%, total fall 55%
At i: Divergence with price fall (D3); rally 80%
At J: Divergence(red line) with price rise (D4), fall 16% but SO didn’t touch 20 this time, while it did in above 3 cases
At L: Divergence(red line) with price rise (D5); Fall so far 10%
So will it be right to trust divergence? Absolutely, as it is followed by massive price movement.
But will be right to trust only divergence for buy or sell? Absolutely not, it should always be used in conjunction with other price action signals.
And now the big question, what is the present scenario in this chart?
Look at the divergence on SO (thick yellow line) and the price movement of the stock and interpret yourself.
Play safe, stay healthy and like if u can.
