Question

Explain how the investment decision can be made from Stochastic and Bollinger Bands Indicator?

Answer 1

Solution:

A] Stochastic Oscillator:

The stochastic oscillator is a widely used momentum indicator. It compares the current price of the security with the highest and the lowest price during a specified period.

The value of the oscillator is computed as:

%k = (Last Closing Price – Lowest Price in the period)/(Highest Price in the period – Lowest Price in the period) x 100

Normally the oscillator charting comes with two lines. One is the computed value of the oscillator and the other is the three day simple moving average of the oscillator.

Analysis part:

1. Overbought and oversold conditions: The Oscillator is range bound between 0 to 100. If the level of the oscillator goes above 80 it indicates overbought condition and if the level goes below 20 it is a oversold condition. Sell signal is generated when the oscillator croses 80 marks and then returns below 80. Buy signal is generated when the oscillator goes below 20 mark and then return above 20.

2. Trend shifts : Oscillator is also use to predict future trend shift. The crossing of the Oscillator line and its 3day SMA line is an indication of trend reversal.

3. Divergence : Oscillator is also used to predict divergence. This happens when the security price is making new lows but that is not reflected in the oscillator. This is a bullish divergence indicating upcoming market reversal. Similarly you can have bearish divergence when price is making new highs but that is not reflected in the oscillator.

Bollinger Bands

It is a 3 set of line drawn on the stock price chart. The central line is a 20 day SMA and upper line and the lower line are two trendlines plotted with two standard deviations above and below the central line.

Analysis:

Most traders believe that the closer the price moves to the upper line, it is an overbought condition and closer the price moves to the lower line, it is a oversold condition.

When the bonds come together, constricting the moving average, we have a squeeze. Squeeze is an indication of low volatility and may result into higher volatility going ahead.

Some traders buy when price touches the lower line and exit when price touches the moving average in the center of the bands. Other traders buy when price breaks above the upper line or sell when price falls below the lower line.

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