Stocks & Commodities V.

23:8 (70-73): Home, Home On The Range by Andrew Tomlinson

CHART PATTERNS

Stochastics And Price Range Dynamics

Home, Home On The Range

Price ranges are used in signaling
both reversals and breakouts.
Looking at how stochastics perform in breakouts sheds light on
several key characteristics of the
indicator.
by Andrew Tomlinson
ne of the trading systems I use is based
on changes in momentum. Theres
nothing particularly
high-tech or unique about it, but it
means that Ive been looking at a
lot of breakouts. And one of the
interesting things about breakouts
is that they often affect indicators
in unexpected ways. They act as a
kind of stress test, pushing market
metrics to extremes, and as a result,
they make me look a little closer. In
my last STOCKS & COMMODITIES
article, I looked at how volume
indicators behaved under stress. On
this occasion, its the behavior of
the stochastics indicator that caught
my eye, particularly when compared
to a Donchian price channel.

DEREK STUKULS

WHAT I FOUND
Figure 1 shows the price action of
McKesson Corp. (MCK) in the autumn of 2004. The upper window
shows the price bars along with 14day price bands of the highest high
and lowest low. The chart shows a
series of downward price breakouts,
most notably on July 1 and September 8. The lower window shows
a 14-bar stochastic.
The first thing I noticed is that
there are no breakouts in the stochastic that is, nothing that
showed a breakout had taken place.
Yes, there was a move to the lower part of the indicator range,
but nothing that distinguished a steady move down to the
bottom of a narrow channel (for example, June 1728, a 7%,
seven-day decline), from an abrupt breakout (September 8, a

16%, one-day drop). The size of the stochastic move was

particularly small if the drop was from the bottom of the
prior range rather than the top. So the July 1st, 12.6% drop
looks like a little blip on the stochastic because the drop was

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 23:8 (70-73): Home, Home On The Range by Andrew Tomlinson

McKESSON CORP.

THE DIFFERENCE A DAY MAKES

37.0
36.0
35.0
34.0
33.0
32.0
31.0
30.0
29.0
28.0
27.0
26.0
25.0
24.0
23.0
22.0

Price bands

90
80
70
60
50
40
30
20
10
0

90
80
70
60
50
40
30
20
10
0

Stochastic
oscillator

1 7 14
June

21

28

6 12 19 26
July

2 9
August

16

23

30

7 13 20
September

27

4 11 16
October

25

1
November

FIGURE 1: BEFORE YOU DECIDE ON YOUR FLAVOR. A series of breakouts in MCK in the autumn of 2004 make
a variety of impacts on the 14-day stochastic.

McKESSON CORP.

36
36
To identify a price breakout, you comPrice bands
34
34
32
pare the current price to the recent
32
30
30
range of prices in the form of a price
28
28
26
26
band, in this case a high/low range. A
24
24
move outside the band constitutes a
22
22
breakout. The calculation of the raw
100
100
50
50
stochastic (the basis of the stochastic
0
0
-50
-50
Price band oscillator
indicator before smoothing) is essen-100
-100
tially the same as that of the price
36
36
34
34
band, comparing the current price to
32
32
the recent range, but with one key
30
30
28
28
difference the reference range inStochastics raw channel
26
26
24
24
cludes the current bar.
22
22
We normally think of a price
100
100
Stochastic
raw
breakout in terms of a price band and
50
50
the stochastic as an oscillator. To com0
0
pare the two, it is useful also to con1 7 14 21 28 6 12 19 26 2 9 16 23 30 7 13 20 27 4 11 16 25 1
figure the stochastic as a price band
June
July
August
September
October
November
and the price band as an oscillator.
Consider Figure 2. The top window is FIGURE 2: PRICE ACTION AND OSCILLATORS. The breakouts are highlighted by the price band and minimized
by the stochastics.
the same as Figure 1, showing price
bars of MCK, along with a price band
calculated as the highest high and the lowest low of the last
Range:= Hhv (Ref(H,-1),14)- Llv (Ref(L,-1),14);
Position:=C- Llv (Ref(L,-1),14);
14 days, excluding the current bar. Thus, in MetaStock, it is
PBOsc:=100*(Position/Range);PBOsc;
simply:

Hhv(Ref(H,-1),14);
Llv(Ref(L,-1),14);

The second window down is the price band oscillator

corresponding to the price band in the top window, being the
close minus the range low, divided by the high/low range.
This is identical to the raw stochastic formula below but
calculated in reference to the preceding 14-day range, so that
breakouts move outside the zero to 100 horizontals, thus:

The third window down is the price action of MCK along

with a raw stochastic channel, calculated as the highest high
and the lowest low of the last 14 days, including the current bar:
Hhv (H,14);
Llv (L,14);

The bottom window is the raw stochastic oscillator corresponding to the raw stochastic channel in the third window,

Copyright (c) Technical Analysis Inc.

METASTOCK

from the bottom of the prior range

that is, the stochastic was already
oversold, unlike the September 9th
drop, which appears much bigger on
the stochastic because the fall was
from the top of the prior range.
This insensitivity when the stochastic is in overbought or oversold territory is illustrated again by the steady
21% decline through September and
October, which shows on the stochastic
as a wobbly line in oversold territory.
The other observation related to the
breakouts is the length of time the stochastic takes to react, so the 16% drop
on September 8 registers on the stochastic only as a drop to 38.8; it doesnt
reach bottom until September 10.
Lets look at these observations in
more detail.

37.0
36.0
35.0
34.0
33.0
32.0
31.0
30.0
29.0
28.0
27.0
26.0
25.0
24.0
23.0
22.0

Stocks & Commodities V. 23:8 (70-73): Home, Home On The Range by Andrew Tomlinson

McKESSON CORP.

being the close minus the range low

divided by the high/low range, or in
MetaStock terms:
Range:= Hhv (H,14)- Llv (L,14);
Position:= C- Llv (L,14);
Raw:= 100*(Position/Range);Raw;

36.5
35.5
34.5
33.5
32.5
31.5
30.5
29.5
28.5
27.5
26.5
25.5
24.5
23.5
22.5
21.5

Stochastic raw channel

36.5
35.5
34.5
33.5
32.5
31.5
30.5
29.5
28.5
27.5
26.5
25.5
24.5
23.5
22.5
21.5
100
90
80
70
60
50
40
30
20
10
0

At first glance, the two price chan100

Stochastic raw
90
nels look fairly similar, but the oscilla(56.3437)
80
70
tors make the differences clear on
60
50
breakout bars. However big the
40
30
breakout, the raw stochastic channel
20
expands to include the new price, so the
10
0
stochastic oscillator always stays in1 7 14 21 28 6 12 19 26 2 9 16 23 30 7 13 20 27 4 11 16 25 1
side the zero to 100 range. In contrast,
June
July
August
September
October
Nov
a breakout shows clearly on the price
band oscillator, sometimes jumping far FIGURE 3: A LOOK AT DIVERGENCES. A detailed look at the divergence in late August and early September
gives clues as to what it is really telling us.
outside the zero to 100 range.
The benefit of including the current
bar is that the stochastic is always bound between zero and indicators to give them early warning that a trend is weaken100 and so provides a consistent definition of overbought and ing; the indicator makes a lower high while prices make a
oversold levels. The downside is that the indicator loses the higher high (or the opposite on the short side). Although
ability to provide useful information about big directional divergences may look similar and be acted on in similar ways,
moves. Its like a car that can go 100 mph with a speedometer they can actually be telling us very different things, dependthat only goes up to 50; beyond a certain point, the needle just ing on the indicator.
gets stuck and fails to give you any more information.
In Figure 3, look at the divergence shown between the
The implication for a stochastics user is that a move into rising price highs on August 25 and September 7, and the
overbought or oversold territory is a signal that the indicator corresponding falling highs in the oscillator. The relationship
is no longer operating effectively. Indeed, that move can be between the price bars and the raw stochastic channel shows
the beginning of a significant extension of the current trend, us whats going on. Remember, the stochastic is simply
a fact that is at the bottom of the stochastic pop strategy showing us where the close is in relation to a high/low range
described by Bernstein and others, where a move into over- that includes the current bar.
bought or oversold territory can be a signal to enter a trade
The close on August 25 is very close to the high of the day,
with, not against, the current trend.
which is also a new 14-day high. It therefore gets a very high
Another way of thinking about this is that the impact of a reading of 97.3 on the raw stochastic. The close on September
given price move on the stochastic indicator varies, depend- 7 is a little further below the high of that dayalso a new
ing on the size of the reference price range. The price move highso it gets a lower reading of 89.2 (the effect is accenof $2.30 (6.4%) from June 16 to 28 shows on the raw tuated by the fact that the high/low range itself narrowed as
stochastic as a major 92.35-point move from 95.19 to 2.84. the mid-August lows dropped out of the calculation). The
The $3.37 (9.7%) drop on July 1, a much bigger price move stochastic doesnt care that the price is higher; all it cares
only a few days later, shows on the raw stochastic as a minor about is where the close is in relation to the high/low range.
20.17-point blip from 36.43 to 16.27. The price band oscilla- So the divergence signal is really just telling us that the bar
tor also adapts, but the inclusion of the current bar in the forming the second high has a longer upper shadow than the
stochastics calculation means that the impact of any big move bar forming the first high (as scaled by the high/low range).
is immediately minimized.
That might signify a weakening of the trend (using the
Above all, its intriguing that only one day separates one of same argument as for a shooting star in candlestick terminolthe main tools used to signify breakouts from one used for ogy), but it could also just result from a slightly weaker close
reversals. This underlies the ambiguity inherent in all channel of the general market or pure randomness. It is not necessarily
methodologies: theyre great at signaling retracements telling us much about the momentum of the price; as this
unless theyre signaling a breakout!
analysis illustrates, stochastics is primarily a price range
indicator, not a momentum indicator.
WHAT DOES A STOCHASTIC
DIVERGENCE REALLY MEAN?
SO WHAT FLAVOR WAS THAT AGAIN?
Looking at the raw stochastic channel and oscillator also The stochastics indicator that we are familiar with smooths
helps shed some light on another aspect of stochastics: the raw stochastic and then shows the smoothed line with its
divergence. Technical analysts look for divergences in many own moving average. However, the smoothing and averagCopyright (c) Technical Analysis Inc.

Stocks & Commodities V. 23:8 (70-73): Home, Home On The Range by Andrew Tomlinson

ing methods can vary according to

which authority you read or which software you use. Here, I am using the
smoothing and averaging calculations
set out by Harry Schirding, except that
he uses a five-day price range, not a 14day one. In MetaStock, the calculation
can be expressed as:
Range:=Hhv(H,14)-Llv(L,14);
Position:= C-Llv(L,14);
Raw:= 100*(Position/Range);{%K}
Quick:=100*Sum(Position,3)/
Sum(Range,3);{%D or Slow %K}
Slow:=Mov(Quick,3,S);{Slow %D}

McKESSON CORP.
Stochastic raw channel
35

35

30

30

25

25

100

Stochastic raw

100

50

50

0
100

0
100

50
0
100

Stochastic
slow K/fast D

Stochastic slow D

50

50
0
100
50

The steps can be seen in Figure 4,

0
0
with the third window down showing
100
100
Stochastic oscillator
the smoothing operation to create slow
50
50
%K, which is then averaged to produce
0
0
slow %D. The two lines are shown
1 7 14 21 28 6 12 19 26 2 9 16 23 30 7 13 20 27 4 11 16 25 1
together in the conventional presentaJune
July
August
September
October
November
tion in the bottom window.
The observation here is to note how FIGURE 4: SMOOTHING THE STOCHASTIC. Breaking down the stochastic into its formula steps shows the
smoothing process.
the smoothing process further diminishes our ability to distinguish a price
breakout from a gentle meander from one edge of a range to know them inside out. In fact, if you want to be more
the other. As we have seen, a 5% price move can look the disciplined about your trading, it is a good idea to formally
same as a 50% move, and this effect is emphasized by the include a description of the indicators you use in your written
averaging calculations included in the smoothed stochastic. trading plan, including your understanding of the market
As with so many oscillators, the price of smoothing is conditions when they are effective and when they are not.
decreased sensitivity Look, the stochastic moved into
oversold there must have been a big move a few days ago. Andrew Tomlinson is an investor, trader, and analyst based
in Montclair, NJ. He was an investment banker for 20 years,
specializing in risk management and derivatives.
SHOULD YOU USE THE STOCHASTIC?
So should you still use the stochastic oscillator? Absolutely
but do take the time to understand what exactly it is telling you. RELATED READING
Indicators are surprisingly precise tools; they can give us a lot Bernstein, Jake [1993]. Short-Term Futures Trading, rev. ed.,
Probus Publishing.
of useful information in some market environments but none
Chande, Tushar S., and Stanley Kroll [1994]. The New Techniat all in others.
cal Trader, John Wiley & Sons.
More broadly, there are implications for other areas of
technical analysis. The issue of when to include todays data Lane, George C. [1984]. Lanes Stochastics, Technical Analysis of STOCKS & COMMODITIES, Volume 2: May/June.
in an indicator is a valid discussion point in many circumstances. So for example, when comparing todays price Larsen, Roy [20045]. MetaStock Tips & Tricks,
[Link]/
action to past price volatility, does it make sense to include
todays action in the volatility reference, be it based on Schirding, Harry [1984]. Stochastic Oscillator, Technical
Analysis of STOCKS & COMMODITIES Volume 2: May/June.
average true range or mean deviation? Divergence is often
seen as a one size fits all approach, but in fact a divergence Steckler, David [2000]. Trading Stochastic Pops, Technical
Analysis of STOCKS & COMMODITIES, Volume 18: August.
reading in one indicator may be telling you something very
different from divergence in another. And all bound oscilla- Tomlinson, Andrew [2004]. A Tale Of Two Indicators, Technical Analysis of STOCKS & COMMODITIES, Volume 22:
tors will be subject to price compression, but this isnt always
October.
a bad thing look at how useful Tushar Chandes stochastic
RSI oscillator (stochRSI) is in emphasizing smaller moves in See our Traders Tips section for program code implementing
the heavily smoothed relative strength index (RSI).
Andrew Tomlinsons technique.
In the end, it comes down to the old advice of picking a
S&C
few well-chosen and diversified indicators and getting to See Traders Glossary
Copyright (c) Technical Analysis Inc.