When using the covered call writing strategy, it is critical to select stocks with positive price momentum. This will increase the probability of maximizing our profits. One of the technical indicators included in the BCI methodology is the stochastic oscillator.
The stochastic oscillator is a momentum indicator that shows the location of the current closing price relative to the high-low range over a set number of periods, usually 14 trading days. Closing levels that are near the top of the range indicate accumulation or buying pressure while those near the bottom of the range indicate distribution or selling pressure. Another way to frame this is that it is the battle between the bulls and the bears and who is in charge. The indicator oscillates between 0 and 100. Readings below 20 are considered oversold while readings above 80 are considered overbought. The idea behind this indicator is that prices tend to close near the extremes of the recent range before turning points.
Let’s set up an example as to how this works. We will assume that during the past 14 trading days stock XYZ has seen a low of $30 and a high of $40. Today it closed at $38. Within the $10 trading range, the stock is $8 up or in the 80%. If the stock closed today at $32, it would be at the 20%. This is known as %K in stochastic lingo. Transaction signals occur when %K crosses its 3-day simple moving average called %D. This is also known as the trigger line. Let’s look at a chart that shows the stochastic oscillator:
- Stochastic Oscillator Chart- Slow
Note the following:
- Stochastic oscillator = thick black line highlighted by the black arrow = %K
- Trigger line = red line highlighted by red arrow = %D
- Overbought (80%) and oversold (20%) levels are highlighted by the green circles.
Some chartists use crossovers of %K and %D as buy/sell signals. However, these signals occur quite frequently and can result in whipsaws or a myriad of short term signals. A more reliable reading (in my view) is when the oscillator moves from overbought (above 80%) to below that level or from below oversold (20%) to above that level. A strong stochastic signal occurs when the positive divergence above 20% or a negative divergence below 80% takes place for a second time or a double dip. Here are the guidelines:
Buy signal: %K crosses above the 20% for the second time
Sell signal: %K moves below the 80% for the second time.
In the chart below, we see a clear buy signal highlighted by the green circle and the price then accelerating as seen by the green arrow. There is also a definite sell signal highlighted by the red circle with the subsequent price decline shown by the red arrow.
- Stochastic Oscillator- Buy and sell signals
Slow versus Fast Stochastics:
One of the problems with %K in relation to %D is the high number of false breaks, whipsaws and crossovers. To mitigate this issue, the slow stochastic oscillator was developed. This is derived by applying a 3-day simple moving average to the %K thereby smoothing the data to form a slower version of %K. An equation that can be used to visualize this would be:
%K (slow) = %D (fast)
Then to form a trigger line for this slower version, a 3-d SMA is created and applied to the new %K (slow).
When building a chart, there is usually a choice of selecting slow or fast stochastics. I always opt for the slow stochastic oscillator as it is easier to read and interpret and eliminates many of the false triggers inherent with the fast oscillator.
Full Stochastic Oscillator:
There is actually a third stochastic oscillator called full stochastics. Rather than being required to use the 3-day SMA of the %K as in the slow stochastics, traders felt that this should be a variable so more flexibility could be achieved. A third variable was created called the smoothing variable which alters the amount of days used in the smoothing of %K. One can also recreate the fast and slow stochastics by the full stochastic. To mimic the fast stochastic, use a 1-day smoothing number. To mimic the slow stochastic oscillator, use a 3-day smoothing number.
For purposes of 1-month covered call writing, I have found the slow stochastic oscillator most useful and time efficient. It is a widely used momentum indicator that measures who is winning the daily battle between the bulls and the bears. As always, it is prudent to use this oscillator in conjunction with our other technical indicators. See chapter 8 of Cashing in on Covered Calls or chapter 4 of the Encyclopedia for Covered Call Writing for a review of all technical indicators used in the BCI system.
We’re off to a great start in 2012…all positive economic reports:
- The US economy added 200,000 jobs causing the unemployment rate to drop to 8.5%, the lowest level since February, 2009.
- In December, the ISM manufacturing index rose from 52.7 to 53.9
- The US Department of Labor reported a 0.2% increase in hourly wages
- The ISM non-manufacturing index rose from 52.0 to 52.6, the first monthly increase since August
- Construction spending rose by 1.2% in November, beating analysts’ expectations
- New orders for manufactured goods increased by 1.8% in November
For the week, the S&P 500 rose by 1.6%, a great start to the New Year.
The market is also shining from a technical perspective as the S&P 500 has moved above both the 50-d and 200-d simple moving averages while the VIX has declined to a very comfortable 20.63: