Premier Stochastic Oscillator Explained

The premier stochastic oscillator (PSO) is a technical indicator based on George Lane's stochastic oscillator. The PSO differs in that it is normalized to register neutral values at zero, resulting in greater sensitivity to recent, short-term price moves. Additionally, the PSO is calculated using a double exponential moving average that creates a smoother and more even response to market changes. Figure 1 illustrates how the two stochastic oscillators respond differently to market changes. 

Tutorial: Exploring Oscillators And Indicators

Figure 1: This chart shows both the premier stochastic oscillator and a standard stochastic oscillator applied to the e-mini Russell 2000 futures contract.

History of the PSOThe PSO was first introduced by technical analyst Lee Leibfarth in the August 2008 issue of the Technical Analysis of Stocks & Commodities. Stochastic oscillators have long been used to help traders and investors identify areas where trend changes are likely. Leibfarth developed the PSO to take advantage of a standard stochastic oscillator's strengths, while enhancing it to become more reactive to market activity. The result is a faster indicator that provides earlier signals for potential trend changes. (To get a better understanding of the traditional stochastic oscillator, check out Exploring Oscillators and Indicators: Stochastic Oscillator.)
Calculating the PSOBefore looking into the calculations of the PSO, it is helpful to understand the logic behind a standard stochastic oscillator. The classic stochastic oscillator measures price momentum by comparing a trading instrument's current price to a price range specified in a lookback period (the number of periods from which price data are collected). For example, if the range is between $60-70 and the current price is $67.50, then the price is at 75% of the range.
The goal of a stochastic oscillator is to figure out where price has been, and anticipate where price is headed. This is achieved by determining if price bars are closing close to their highs or lows. When prices are closing nearer to bar highs, it is indicative of an uptrending market. Conversely, when prices are closing nearer to bar lows, it signifies a down-trending market. The basic calculation for the main value of a standard stochastic oscillator (%K) is:

%K = 100 X [(C – Ln) / (Hn – Ln)]

Where

• C = the most recent closing price
• n = the lookback period
• Ln = the low of the n previous price bars
• Hn = the highest price during the same n period

The premier stochastic oscillator normalizes the standard stochastic oscillator by applying a five-period double exponential smoothing average of the %K value, resulting in a symmetric scale of 1 to -1. The PSO calculation, then, is:

PSO = (exponential value (S) – 1) / (exponential value (S) + 1)

Where

• S = 5-period double smoothed exponential EMA ((%K – 50) * .1)
• %K = 8-period stochastic oscillator

(Note: The TradeStation EasyLanguage code for the premier stochastic oscillator is available at www.PowerZoneTrading.com.)
Interpreting the PSOThe PSO appears as a curving line with four horizontal lines that represent threshold levels. These threshold levels are customizable; that is, the levels can be changed by the user to adapt to individual trading styles and instruments. Figure 2 shows the PSO, appearing on a sub-chart below the price chart, with the four different threshold levels.  

Figure 2: A chart of the e-mini Russell 2000 futures contract showing the PSO and its four threshold levels.

The threshold levels are important to the indicator because they can be used to identify areas where market reversals are expected to occur. As the curved line meanders up and down, it crosses above and below the threshold levels. The "outer" thresholds, at the very top and very bottom, represent the extremes, or areas that are overbought (the top line) or oversold (the bottom line). When the PSO moves above the upper or below the lower, price will be expected to pullback.
The "inner" thresholds are placed near the zero line and can be utilized as a transitional area to spot pullbacks and short-term reversals. As the PSO returns from overbought and oversold areas, price has a tendency to accelerate towards the zero line and reverse. This transitional area (between the inner thresholds) can be useful in spotting short-term reversals. (Read more on these types of setups in Ride The RSI Rollercoaster.)
Trading with the PSOThe PSO can be used to anticipate changes in market direction. With the ability to change where the threshold levels appear, the PSO is adaptable to different trading styles. The PSO can easily be incorporated into a counter-trend type strategy since it is used to identify changes in market direction. The following are suggested uses for the PSO, understanding that each trader or investor would need to adjust the indicator to suit his or her needs.
Outer Threshold SetupsOuter threshold setups form when the PSO crosses out of the outer limits and then returns. As previously mentioned, price has a tendency to pullback and then return to overbought or oversold areas. This can provide a good entry point to:

• Go long when the PSO crosses below the upper threshold (0.9 in this example) after it has already crossed above the threshold. A short-term reversal may occur where price returns to the extreme overbought territory.
  
• Go short when the PSO crosses above the lower threshold (-0.9 in this instance) after it has already penetrated the lower threshold. Again, a short-term reversal may occur as prices make another push lower.

 

Figure 3: This chart of the e-mini Russell 2000 futures contract shows potential long (buying) positions using both the outer and inner thresholds.

Inner Threshold SetupsInner threshold setups that can be identified when the PSO comes from the outer thresholds and accelerates towards the center (zero) line. This can present an opportunity to:

• Go long when the PSO comes from overbought areas (0.9 in this instance) and crosses the inner threshold level (0.2 in this example). Unlike the outer threshold setups, the PSO does not need to re-cross the threshold level to trigger the setup.
• Go Short when the PSO returns from an oversold region (-0.9 in Figure 3) to the inner threshold level (in this example, -0.2). (Note: the Go Short example is not shown in Figure 3)

Figure 3 shows a chart with long setups highlighted, using both the outer and inner threshold examples. For short trades, the logic can be reversed. Please note the premier stochastic oscillator is not a strategy; rather, it is an indicator that can be used as part of a trader's or investor's toolbox. As with any market analysis tool, this indicator needs to be optimized to fit each trader's style and preferred trading instrument. (These tools put the market - and any evaluations - in your hands. Check out Economic Indicators For The Do-It-Yourself Investor, and you might also want to read World's Wackiest Stock Indicators.)
ConclusionThe classic stochastic oscillator has been used since the 1950s by traders and investors to anticipate areas where the market may change direction. The classic and premier stochastic oscillator are based on price movement that occurs within the price bar itself – whether bars are closing nearer to their highs or lows – to determine which way the market is heading. The premier stochastic oscillator creates a smoother, faster reacting Stochastic that can help traders and investors determine areas where direction changes are probable – sooner than a standard stochastic – enabling participants to catch a bigger part of a move. (The futures market is a lot less scary when these indicators are used to establish current trends. See Master Futures Trading With Trend-Following Indicators for more.)