The Stochastics and the Williams Percent R Oscillators
The function of the markets serves as a fair-price discoverer. The instantaneous price of an asset reflects all the information all markets participants know about it. When new information comes that changes its perception of value, the market action creates a new trend, pushing the price toward a different “fair” price.
However, the rest of the time, when the asset is already within an agreed “fair price”, what happens to the price? Does it remain at a single location until a new event moves it?
Prices do not stay still because there are millions of participants, everyone with their ideas and goals. That makes it unlikely that a constant fair price exists at all. Jesse Livermore said that the two biggest market forces are greed and fear. These two forces are the main drivers of price change.
When a market lacks the power to maintain a trend, it tends to make oscillatory price changes. But traders use different time frames, price targets, and stops. That makes this oscillation very complex, with several cycles blended on an elaborate and, conceivably, noisy pattern. By noisy I mean random, unpredictable price movements.
The physical sciences have been dealing with fluctuations and cycles for long. Almost anything in physics deals with oscillations and vibrations. Hence, cycles are one of the market conditions that can be examined with definite scientific accuracy, limited only by the random nature of prices.
On this article, we’re going to investigate a computerized study which will help traders with the cyclic side of the market: The Stochastics Oscillator.
The Stochastics study was created by George Lane, who show it during his investment seminars since 1950. Lucas and LeBeau in his book “Computer Analysis of the Futures Markets” wrote that Mr Lane has been improving the use of stochastics applied to trade over many years, and he can make it work properly in most market situations.
The Stochastics Oscillator arose from the observation that the close tends to happen near the high of the range during uptrends and near the low of the range at downtrends.
This study measures where the close happens, relative to the range of prices over a specified period. The %K line comes from a simple formula that makes sure the signal is always between zero and 100:
The %D line, which is called slow stochastic and is measured by applying a three-day moving average to the %K line.
it is understood that an overbought market is in place when its stochastics lines – %K and %D – are above the +80 level; while a market is in an oversold state when the price is below the 20 level.
A classic way to use of Stochastics as a trigger signal is by acting when %D and %K crossover if this happens at the extremes. A second style is to act when the %D line crosses – over or under- the price triggers (+20, +80). For example, when %D crosses under the 80 level, it indicates a sell signal, and when it crosses over the 20 level, it’s a buy signal.
The usual period for the Stochastic oscillator is 14, but, Lucas and LeBeau mention that George Lane used an aligned value of 50% the length of the perceived main market cycle. Lucas and LeBeau in their book about trading systems for the futures markets said that they had tested several periods on this oscillator, and a range between 9 and 12 were the top performers. Using this range they obtained the best trade-off between speed and signal soundness, presenting the minimum amount of wrong signals.
What this shows is that you need to experiment with the period of this study and back-test its results, to get an optimal figure for the current market you are treading.
Also worth noting, Alexander Elder in his book “The new Trading for a Living” wrote that if you intend to use Stochastics as your sole trading signal, it’s better to choose a longer-term period, while in combination with other studies a shorter period is preferable.
Signals against the trend
As mentioned in the beginning, this kind of oscillators is best suited for cyclic phases of the market. When the price is moving on a trend, the Stochastic oscillator does not function that well, notably when the Stochastic signal aligns against the main trend.
Fig. 2 shows the Stochastics used in a downtrending market (NZDUSD). We can see that most of the good signals come from the overbought side. That is so because the trigger signals align with the main trend, even when happening before %K and %D touches the overbought region. This situation is usual in strong trends. The price doesn’t give the oscillator the chance to reach the overbought ( or oversold) level, returning to the main trend well before it. The only good buy signal came at the end of this long downtrend when the oversold condition shows up in several time frames.
In his book, LeBeau and Lucas said: “Remember: The trader who coined the phrase ‘the trend is your friend’ was not using stochastics”.
Many authors state that divergence between price action and Stochastics is one of the most strong signals.
A bullish divergence arises when the price makes a new bottom and the Stochastics fail to do so forming a higher one.
A bearish divergence happens when prices make higher peaks, but the Stochastics line forms a lower top.
Knees and Shoulders
When %K crosses over %D and then pulls back, approaching, but not piercing, %D, and, next, it resumes its upward movement, Mr Lane names it a knee. If the movement is to the downside, he calls it a shoulder. According to Mr Lane, it shows a continuation with strength.
Anticipating a crossover
Some people recognise when %D flattens, calling it a hinge. Also, there’s a warning hook, when both %K and %D turns at an extreme but still don’t meet.
According to LeBeau and Lucas, Kees and Shoulders aim to anticipate the price action but lacks reliability, and doesn’t recommend its use. It’s better to wait for a crossover.
Bear and bull setups
Another unique tool by George Lane.
A bear setup occurs when the price action creates a sequence of higher highs and higher lows, but the Stochastics draws a pattern of lower bottoms when prices are still rising. This pattern indicates there will be a top soon.
A Bull setup is the mirror pattern of bear setup, showing that a bottom may soon happen.
Williams Percent R is also a momentum indicator created by Larry Williams, comparable to the Stochastic indicator, but on this case, it measures the level of the close relative to the highest high of a given period, and it doesn’t draw a smoothed %D line.
Thus, this oscillator moves from -100 to 0. levels below -80 are considered as oversold while above -20 to 0 overbought.
Some charting packages shift these values to positive 0 to 100 by adding 100 to the formula. In this case, oversold are values between 0 and 20 and overbought from 80 to 100.
%R is bumpier than Stochastic %D, although showing less delay. Therefore, it usually triggers earlier for a better reward to risk ratio.
This indicator is very good at detecting oversold conditions at an uptrend, or overbought levels at a downtrend, therefore, it’s well suited as a signal, to add to a position or enter a new one on pullbacks.
Usual Entry Rules
Period: The 10-day or bar period is the standard. The trader should count the usual number of bars his particular market taken from peak to peak and divide it by two.
Filter: Larry Williams recommends first to find the main trend direction and, then, only take the signals that go with this trend.
Long trigger: 1 %R has reached the oversold zone and then crosses upwards leaving the zone.
Short Trigger: %R has reached the overbought area and then moves down out of the overbought area.
Computer Analysis of the Futures Markets, LeBeau and Lucas