If you knew the future price of assets when creating a portfolio, it would be the best way to become a millionaire. However, this is difficult (if not impossible), so what if you knew what would be the movement of the price, instead? It could be enough to earn money!

To predict price trend isn’t a simple job, and there’s no method that tells you what the movement will be with 100% accuracy. But, if you’re not too demanding, you can find many methods that predict the trend with adequate confidence.

In this area, we describe the Stochastic Oscillator, developed by George C. Lane in the late 1950s. This is a momentum indicator that locates the price related to the maximum and minimum price in a certain period. In the words of Lane, “the stochastic oscillator does not follow the price but the speed or the momentum of the price; as a rule, the momentum changes the direction before the price.” Therefore, this indicator can be used as a prediction of the change of the price direction. The Stochastic Oscillator is a reversal indicator!

This indicator tells you when prices will start to trend down (highlighting a good moment to sell). It can also tell you when they will start to go up, (highlighting a good moment to buy). When prices move closer to their historical maximum or their historical minimum (if the time period is selected by us), the probability of a change in the price movement will be very high.

In other words, if prices are moving closer to their historical maximum: sell! because they will probably go down. If prices are moving closer to their historical minimum: buy! because they will probably go up and you will earn.

How does the indicator work?

It’s very easy, with no added difficulties. You only need to set one parameter: how do we define the period? A period of 14 is commonly used. These can be days (14 daily prices), weeks (14 weeks), years (14 years) – etc. Once this parameter is set, the stochastic oscillator can be calculated. We take the last available price, we calculate the historical maximum price and the historical minimum price, and following the next formula, here is the indicator:

By definition, the stochastic oscillator only takes values between 0 and 100. If the value of the indicator is close to 0, the price is around the minimum and then… you should buy. If the value is close to 100, the price is around the maximum and it is the moment to sell.

Our experiment

We will try to manage a stock portfolio based on this indicator, but we will only focus on the “buy signals”. At each recommendation day, once a week, we will buy the 50 stocks with lowest stochastic oscillator value, using a 14-day period to calculate the value of the stochastic oscillator.

In order to avoid excessive trading, we will also manage another portfolio. Here, we will sell stocks if their stochastic oscillator value is over 80. In this way, we hold the stocks until we think their price will start to change, thus reducing the number of trades.

Portfolio 2, which holds the stocks with higher values of the indicator, gets poorer results than Portfolio 1. Except for the last years, when it slightly outperforms Portfolio 1.

The big achievement of these portfolios is that they outperform the S&P500 Index on the basis of its components, except in 1998, 2007 and 2012 (marked in red in the Annual Returns graph).

The risk taken by these portfolios in the latest years is significantly higher than the risk taken by the index. However, it seems that the increased risk is worth it when taking the outstanding results into account.

To conclude

The good behaviour of the stochastic oscillator as a reversal indicator, over the S&P500 stocks, has been proven. You can use it to decide how to manage your portfolio and get acceptable results. You take addtional risk in exchange, but in life you have to experience intense emotions!