Technical Indicators: - Stochastic Oscillator - Relative Strength Index - Moving Average Convergence-Divergence

Technical Indicators
•Stochastic Oscillator
•Relative Strength Index
•Moving Average Convergence-
Divergence
Goals for the session:
• To learn how to use Stochastic, RSI and MACD
effectively in stock trading.
• To learn how to spot bull and bear
signals/patterns and form a buy/sell decision.
• To minimize the risk of losses when doing
trades.
Stochastic Oscillator
• Developed by George C. Lane in the

late 1950s, the Stochastic Oscillator is
a momentum indicator that shows
the location of the close relative to
the high-low range over a set number
of periods.
“The Stochastic Oscillator doesn't

follow price, it doesn't follow volume
or anything like that. It follows the
speed or the momentum of price. As a
rule, the momentum changes
direction before price."
How to calculate the S.O.?
• %K = (Current Close - Lowest Low)/(Highest High -

Lowest Low) * 100
• %D = 3-day SMA of %K Lowest Low = lowest low for
the look-back period
• Highest High = highest high for the look-back period
• %K is multiplied by 100 to move the decimal point
two places
Interpretation
Buy when the Oscillator (either %K or %D) falls
below a specific level (e.g., 20) and then rises
above that level.
Sell when the Oscillator rises above a specific
level (e.g., 80) and then falls below that level.
Buy when the %K line rises above the %D line
and sell when the %K line falls below the %D
line.
Overbought and Oversold Levels
• As a bound oscillator, the Stochastic

Oscillator makes it easy to identify
overbought and oversold levels.
• The oscillator ranges from zero to one
hundred.
• Traditional settings use 80 as the
overbought threshold and 20 as the
oversold threshold.
• Readings above 80 for the 20-day
Stochastic Oscillator would indicate
that the underlying security was
trading near the top of its 20-day high-
low range. Readings below 20 occur
when a security is trading at the low
end of its high-low range.
Bull and Bear Divergence
Divergences form when a
new high or low in price is
not confirmed by the
Stochastic Oscillator.
Bull and Bear Divergences
Bullish Divergence Bearish Divergence

• A bullish divergence forms when • A bearish divergence forms when
price records a lower low, but the price records a higher high, but
Stochastic Oscillator forms a the Stochastic Oscillator forms a
higher low. This shows less lower high. This shows less upside
downside momentum that could momentum that could foreshadow
foreshadow a bullish reversal. a bearish reversal.
Bull and Bear Divergences
Bullish Divergence Bearish Divergence

Bull and Bear Set-ups
Bull Set-up
• A bull set-up is basically the
inverse of a bullish divergence.
The underlying security forms
a lower high, but the Stochastic
Oscillator forms a higher high.
Even though the stock could
not exceed its prior high, the
higher high in the Stochastic
Oscillator shows strengthening
upside momentum. The next
decline is then expected to
result in a tradable bottom.
Bull and Bear Set-ups
Bear Set-up
• A bear set-up occurs when the
security forms a higher low, but
the Stochastic Oscillator forms a
lower low. Even though the stock
held above its prior low, the
lower low in the Stochastic
Oscillator shows increasing
downside momentum. The next
advance is expected to result in
an important peak.
Conclusions
• While momentum oscillators are best suited for trading ranges,
they can also be used with securities that trend, provided the
trend takes on a zigzag format. Pullbacks are part of uptrends that
zigzag higher. Bounces are part of downtrends that zigzag lower.
In this regard, the Stochastic Oscillator can be used to identify
opportunities in harmony with the bigger trend.
• The settings on the Stochastic Oscillator depend on personal
preferences, trading style and timeframe. A shorter look-back
period will produce a choppy oscillator with many overbought and
oversold readings. A longer look-back period will provide a
smoother oscillator with fewer overbought and oversold readings.
• Like all technical indicators, it is important to use the Stochastic
Oscillator in conjunction with other technical analysis tools.
Volume, support/resistance and breakouts can be used to confirm
or refute signals produced by the Stochastic Oscillator.
For further studies:
Book: Technical Analysis of the Financial Markets by
John J. Murphy. This book has a chapter devoted to
momentum oscillators and their various uses. Murphy
covers the pros and cons as well as some examples
specific to the Stochastic Oscillator.
Book: Technical Analysis Explained by Martin Pring.

This book shows the basics of momentum indicators by
covering divergences, crossovers and other signals.
There are two more chapters covering specific
momentum indicators with plenty of examples.
Questions?
Relative Strength Index
Developed J. Welles Wilder, the Relative

Strength Index (RSI) is a momentum oscillator
that measures the speed and change of price
movements. RSI oscillates between zero and
100. Traditionally, and according to Wilder,
RSI is considered overbought when above 70
and oversold when below 30. Signals can also
be generated by looking for divergences,
failure swings and centerline crossovers. RSI
can also be used to identify the general trend.
Calculation
RSI = 100 – (100/ 1 + RS)

RS = Average Gain / Average Loss
To simplify the calculation explanation, RSI has been broken down

into its basic components: RS, Average Gain and Average Loss..
Losses are expressed as positive values, not negative values.
The very first calculations for average gain and average loss are
simple 14 period averages.
• First Average Gain = Sum of Gains over the past 14 periods / 14.
• First Average Loss = Sum of Losses over the past 14 periods / 14
The second, and subsequent, calculations are based on the prior
averages and the current gain loss:
• Average Gain = [(previous Average Gain) x 13 + current Gain] / 14.
• Average Loss = [(previous Average Loss) x 13 + current Loss] / 14.
Overbought - Oversold
• Like many momentum

oscillators, overbought
and oversold readings
for RSI work best when
prices move sideways
within a range.
• The stock peaked soon
after RSI reached 70 and
bottomed soon after the
stock reached 30.
Divergences
• Divergences signal a potential reversal point
because directional momentum does not confirm
price.
• A bullish divergence occurs when the underlying
security makes a lower low and RSI forms a
higher low. RSI does not confirm the lower low
and this shows strengthening momentum.
• A bearish divergence forms when the security
records a higher high and RSI forms a lower high.
RSI does not confirm the new high and this shows
weakening momentum.
Positive-Negative Reversals
A positive reversal forms

when RSI forges a lower low
and the security forms a
higher low. This lower low is
not at oversold levels, but
usually somewhere between
30 and 50.
Positive-Negative Reversals
A negative reversal is
the opposite of a
positive reversal. RSI
forms a higher high, but
the security forms a
lower high. Again, the
higher high is usually just
below overbought levels
in the 50-70 area.
Conclusions
• The Relative Strength Index (RSI), a popular
momentum oscillator, is extremely useful in
the application of technical analysis. It is widely
accepted that if the RSI rises above 30, it is
considered bullish for the underlying stock. On
the other hand, if the RSI falls below 70, it is a
bearish signal.
• Shows how strongly a stock is moving in its
current direction by following the speed of its
price action.
Questions?
Moving Average Convergence-
Divergence
• Developed by Gerald Appel in the late 70’s
Moving Average Convergence-Divergence
(MACD) is one of the simplest and most
effective momentum indicators available.
• MACD turns two trend-following
indicators, moving averages, into a momentum
oscillator by subtracting the longer moving
average from the shorter moving average.
Calculation
MACD: (12-day EMA - 26-day EMA)
Signal Line: 9-day EMA of MACD
MACD Histogram: MACD - Signal Line
• Standard MACD is the 12-day Exponential Moving

Average (EMA) less the 26-day EMA. Closing prices are
used for these moving averages. A 9-day EMA of
MACD is plotted with the indicator to act as a signal
line and identify turns.
• The MACD-Histogram represents the difference
between MACD and its 9-day EMA, the signal line.
• The histogram is positive when MACD is above its 9-
day EMA and negative when MACD is below its 9-day
EMA.
Signal Line Crossovers
• Signal line crossovers are the

most common MACD signals. The
signal line is a 9-day EMA of
MACD. As a moving average of
the indicator, it trails MACD and
makes it easier to spot turns in
MACD.
• A bullish crossover occurs when
MACD turns up and crosses above
the signal line.
• A bearish crossover occurs when
MACD turns down and crosses
below the signal line. Crossovers
can last a few days or a few
weeks, it all depends on the
strength of the move.
Divergences
• Divergences form when MACD

diverges from the price action of
the underlying security.
• A bullish divergence forms when
a security records a lower low
and MACD forms a higher low.
The lower low in the security
affirms the current downtrend,
but the higher low in MACD
shows less downside momentum.
Divergences
• A bearish divergence
forms when a security
records a higher high and
MACD forms a lower
high. The higher high in
the security is normal for
an uptrend, but the lower
high in MACD shows less
upside momentum.
• Divergences should be taken with caution. Bearish
divergences are commonplace in a strong uptrend, while
bullish divergences occur often in a strong downtrend.
• Uptrends often start with a strong advance that
produces a surge in upside momentum (MACD). Even
though the uptrend continues, it continues at a slower
pace that causes MACD to decline from its highs. Upside
momentum may not be as strong, but upside
momentum is still outpacing downside momentum as
long as MACD is above the zero line.
• The opposite occurs at the beginning of a strong
downtrend.
Conclusions
• MACD is special because it brings together
momentum and trend in one indicator.
• MACD is not particularly good for identifying
overbought and oversold levels because it has
no upper or lower limits to bind its
movement.
Questions?

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Technical Indicators

• Developed by George C. Lane in the

“The Stochastic Oscillator doesn't

• %K = (Current Close - Lowest Low)/(Highest High -

• As a bound oscillator, the Stochastic

Bullish Divergence Bearish Divergence

Bullish Divergence Bearish Divergence

Book: Technical Analysis Explained by Martin Pring.

Developed J. Welles Wilder, the Relative

RSI = 100 – (100/ 1 + RS)

To simplify the calculation explanation, RSI has been broken down

• Like many momentum

A positive reversal forms

• Standard MACD is the 12-day Exponential Moving

• Signal line crossovers are the

• Divergences form when MACD

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