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

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

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.

One of the trading systems I use is based on changes in momentum. There’s nothing particularly high-tech or unique about it, but it means that I’ve 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, it’s the behavior of the stochastics indicator that caught my eye, particularly when compared to a Donchian price channel.

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 14-day 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 17–28, 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.