momentum. Points A and appear much weaker in the stochastic than on the line chart, while points and D are more pronounced. The low at point E is confusing, perhaps due to the gap in data; otherwise, the stochastic would seem a unique and usefiil tool. The smoothed value "oD-slow does not lag as much as the 3-day average would imply supporting the premise that there is significant weighting given to the more recent prices. The first calculation, "cK, is not used due to its instability.

Interpreting the Stochastic

The initial trading signal occurs when the "oD-slow crosses the esfreme bands. Suggested in the range of 75 to 85 on the upside, and 15 to 25 on the downside. The order, however, is not placed until the "oK-slow line crosses the W loD-slow line (considered the signal line) . Even though the exfreme zone helps assure an adverse reaction of minimum size. The crossing of the two lines acts in away similar to a dual moving average sjstem. By waiting for the crossover, the trader cannot be trapped into shorting an extremely bullish move or bujing a bearish one.

The emphasis in interpretation of the stochastic is its divergence from the apparent direction of prices. Referring again to Figure 6-7, points A and are declining while new high prices at A are tested at B. This divergence is an important confirmation of the sell indication.

Pattems noted by Lane are more extensive than other writings. They include.

Left and Right Crossovers

Tjpically, the faster "oK-slow will change direction sooner than the "oD-slow. crossmg the "oD-slow line while it is still moving in the prior frend direction. The opposite case, when the "oD-slow tums first indicates a slow, stable change of direction and is a more favorable pattem (Figure 6-8a).

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FIGURE 6-7 The stochastic. A 5-minute bar chart of July 1984 cotton futures (NewYork Cotton Exchange) as recorded by a Commodity Quote-GraphicsTQ-20120 satellite sjstem. Cottons 5period stochastic is plotted below the bar chart.

Hinge

reduction in the speed of either the "oK-slow or "oD-slow hues, shown as aflattenmg out. indicates a reversal on the next day (Figure 6-8b).

Warning

An extreme turn in the fester "oK-slow (2 to 12>o) indicates at most 2 dajs remaining in the old trend. Rxtremes

Reaching the extreme " oK-slow values of 0 and 100 requires 7 consecutive dajs of closes at the highs (lows). The test of this extreme, following a pullback, is an excellent entry point.

Setup

Although the line chart shows higher highs and lows, if the "oD-slow line has lower lows, a bear market setiqa has occurred. Look for a selling opportunity on the next rally (Figure 6-8c).

An excellent confirmation of a change in direction occurs when "oK-slow crosses "oD-slow ("after penetrating the extreme level) then pulls back to the "oD-slow line, but fails to cross it again (Figure 6-8d).

FIGURE6-8 Lanes pattems. (a) Left and right crossings, (b) Hinge, (c) Bear martlet setup. (djoKslow failure.

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Left crossing Righi crossing

Relative Speed and Patterns of the Stochastic and RSI

Increasing the calculation period is a way of smoothing the values of indicator, whether it is viewing weekly instead of daily prices, using a 200-day average instead of a 10-day, or selecting a 20-day stochastic over a 5day. The two most popular oscillatcrs, the RSI and stochastic, can be very similar if the time periods are chosen correctly. In Figure 6-9, a Treasurj bond chart for June 1996 delivery is used to show how the RSI and stochastic pattems change by varjing the number of dajs in the calculation.

The 5-day raw stochastic is shown in panel b of Figure 6-9. Its characteristic is that whenever prices close on a 5-day high or low, the stochastic value is 100 or 0 and the indicator cannot provide any value. Smoothing the raw value offsets this problem at the cost of introducing a lag; this example will avoid that additional problem and use only the raw stochastic. Figure 6-9 (panel c) contains a 5-day RSI that tends to show similarities to the 5-day stochastic as bond prices become more actively traded toward the right part of the chart. Nevertheless, the RSI does not tend to approach peak values. Smoothing the stochastic by using 20 dajs, as shown in Figure 6-9 (panel d), gives a very similar picture

as the 5-period RSI in panel of Figure 6-9. The pattem has all the sarne ups and downs, although the stochastic continues to show more extreme values. The last two panels of Figure 6-9 (panels and f) compare the standard 14-period RSI with a much longer 40-day stochastic with similar results as in Figure 6-9 (panels and d). The pattems are very similar, but the stochastic moves to extremes more often

Creating a Stochastic from the RSI

Any series or indicator value can be converted to a raw stochastic, "cK without adding lag by replacing the closing price with the indicates value. This creates a measure of where that indicates lies in its high-low range over the period selected and may simplify the comparison needed to generate buy and sell signals. A stochastic created from an RSI would be,

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FIGURE6-9 Comparison of RSI and stochastic. (Panel a) Treasury bond prices for the June 1996 delivery. (Panel b) The 5-day raw stochastic often reaches maximum andminimum Val.ues. (Panels and d) Comparing the 5-day RSI with the 20-day stochastic. (Panels e and f) Comparing the 14-day RSI with the 40day stochastic.

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