OTCPicks Penny Stock Blog

Most fans of technical analysis of penny stocks will tell you that learning about momentum is one of the basic tasks of a technical indicator, and the stochastics oscillator is one of the most popular indicators for doing exactly that. Originally developed by Dr. George Lane in the 1950s, this indicator seeks to predict buy and sell signals by comparing a stock’s closing price to its range of prices over a given number of time periods.

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The Formula

In simple terms, stochastics look at the closing price as a percentage of the high-low range over the number of periods. The basic formula is:

%K=100((Recent Close – L)/(H-L))

The H and L represent the highest and lowest close over a certain number of time periods (n), typically 14. The indicator takes a 3 period moving average of this %K to get %D, which is then plotted.

Fast and Slow Stochastics

In this case, %K is the raw data, and %D is a short moving average of that, so the lines see a lot of action and react quickly to the market. This is a fast stochastic, and many investors prefer smoothing out this action to avoid false signals.

It is common for traders to use slow stochastics, in which %K(slow) is a 3 day moving average of the raw %K(fast), and then %D(slow) is a 3 day moving average of %K(slow). Note that in slow stochastics, %K is actually the same as what %D(fast) is and %D(slow) is actually a moving average of a moving average.

Using Stochastics as Indicators

Since stochastics are a percentage of the high-low range, the value will always be between 0 and 100. The first use of the stochastic oscillator looks at this percentage to indicate whether a penny stock is overbought or oversold. When stochastic lines are over 80, the stock is overbought and it is a bearish signal, while stochastics under 20 are oversold. Another method is to wait for the stochastic line to either cross down below the 80 threshold before selling and waiting for it to cross over the 20 mark to buy.

Another way to use stochastics as indicators is to look for crossovers between %K and %D, since %K is faster moving and can signal a trend when compared with a slower %D line. When %K crosses from above to below %D, it hints at an upcoming sell off, and %K crosses from below to above %D signal a bullish trend and are a buy signal.

The third way to use stochastics as indicators is to look for divergences between the stochastic lines and the stock price chart. This is done by looking at trends in the two graph’s resistance and support lines, which connect the highs of the peaks and the lows of the valleys respectively. For example, you might see the stock chart have a flat resistance line which looks like the highs will maintain, but the resistance line of the stochastics could be descending. This would act as an early warning of a sell off when things look otherwise bullish on the price chart.

Like all indicators, false signals are possible and several types of indicators as well as date ranges should be combined to get a stronger and stronger sense of market conditions. With that said, stochastics offer an interesting look at where a stock is trading in relation to its recent range and can be very useful indicators when trading penny stocks.