ShmoopTube

00:00

Finance Allah Shmoop What is Stochastic analysis Stochastic analysis is

00:11

a method of determining the rate at which the value

00:14

of a random variable like the price of a stock

00:17

is changing But obviously we contract the price of a

00:20

stock like every trading platform ever devised Contract the closing

00:24

prices of the stock and plot um for us But

00:27

there's more to it than just tracking the stock price

00:29

and reaching some arbitrary price point And then you know

00:32

selling or buying based on what some crystal ball tells

00:35

you to do What about the speed at which the

00:38

price is changing Dirt inks Stock has been rising pretty

00:42

steadily over the last six trading days since they announced

00:44

a breakthrough in their dirt production process which has led

00:47

to tons of investors Jumping on board Is buyers driving

00:51

up the price right That's what drives up prices more

00:54

demand than supply You want to hit your wagon to

00:56

the gravy train But what if the price gains are

00:58

slowing In other words the price is still increasing but

01:02

increasing by less and less each day indicating that the

01:05

stock is possibly reaching a maximum value before Oh no

01:09

then maybe a correcting downward If we could also measure

01:13

the rate at which the prices air changing Well we

01:15

might be able to predict when or if the price

01:18

is going to reach a maximum value Like example Let's

01:22

say you're the getaway guy for a bank robbery but

01:24

the pressure gets to be too much for you and

01:27

you take off the stranding your former friends Now what

01:30

if we not only track the speed of your car

01:33

but also the rate at which the speed is changing

01:36

Your car still might be speeding up from fifty miles

01:39

an hour to sixty sixty five sixty seven but it's

01:43

speeding up at a slower and slower rate But the

01:46

decreasing rate at which the speed is changing indicates that

01:49

you the driver might be reaching a top speed Soon

01:53

We stress the might because it's not a guarantee here

01:56

Nor is it a guarantee in forecasting future movements So

01:59

getting back to sea stocks It's absolutely true that changes

02:02

in the rate of change of stock price can often

02:04

precede the stock price reaching a high point or a

02:06

low point or even topping out and then dropping or

02:09

bottoming out and then rising again right It's kind of

02:12

random Well stochastic analysis is a great way to forecast

02:15

possible price changes We're getting a look under the hood

02:18

of the stock Not just that the actual performance of

02:21

the stock but at the rate at which that performance

02:24

is changing kind of helps investors attach odds of a

02:27

stock going up and hitting some point or going down

02:30

hitting some other bad point And they can actually then

02:32

make bets that kind of reflect the odds or what

02:35

they think will happen effectively We're not only going to

02:37

look at the way the stock looks in the mirror

02:39

but also look at it inner workings like an X

02:42

ray we see in the mirror It's well just chart

02:45

of closing price is plotted over time What we see

02:47

in the stochastic analysis X ray machine is a measure

02:50

of the rate at which those prices are changing So

02:52

let's start by acknowledging the elephant in the room How

02:55

does measuring the mo mentum of the stock help us

02:58

We'll take a look at the closing prices of a

03:00

big fat growth mojo company Facebook For a time the

03:03

closing prices of Facebook were closing higher and higher values

03:07

each day from left to right across this timeline we

03:09

see that the prices in general continually closing at higher

03:12

and higher values But if we examine the growth we

03:15

see it doesn't always happen at the same rate For

03:17

the first half of this plot well we can see

03:19

the price increases from one seventy knew about one seventy

03:21

eight a difference of eight bucks Check out the middle

03:24

of the graph about three quarters the way across there

03:26

the price started one seventy eight The middle went upto

03:28

one eighty three a difference of five bucks While the

03:30

price is still increasing but not as fast it went

03:33

up fewer dollars in less time than the first time

03:36

right from three quarters of the way to the end

03:39

It's still increasing but now at an even slower rate

03:42

that about three quarters the way along the plot we

03:44

were at price of one eighty three And crossing that

03:47

final quarter on Lee showed growth of another in to

03:50

wish bucks right Well the rate at which the prices

03:52

are climbing is slowing clearly In other words the moment

03:56

um of the stock price is decreasing from what it

03:58

was at the far left Over here we can mash

04:01

the accelerator the floor and our speed goes up very

04:04

quickly Or we can use a light touch on the

04:06

gas pedal and increase our speed slowly The first case

04:09

our speed has large momentum In the second case our

04:11

speed has little mo mentum There are four obvious patterns

04:15

related to a stocks mojo which are calculated using stochastic

04:18

analysis that we should be aware of There are other

04:20

more subtle patterns here is well but well we're just

04:23

going to skip him for now But stocks price could

04:25

be climbing from day to day but the momento of

04:27

the stock could be decreasing In other words the rate

04:30

of growth is slowing This could but doesn't have to

04:33

indicate that the price is going to reach a peak

04:35

and then begin to drop The stock's price could be

04:37

decreasing and the mo mentum of the stock also decreasing

04:41

In other words the rate of the decline is slowing

04:43

down This might be a clue that the price will

04:45

bottom out soon rebound and start to increase again again

04:48

with the word might here being the key words No

04:51

guarantee ever particularly in stock picking We could have a

04:53

stock with a continually increasing price profile This stock could

04:56

also have an increasing MO mentum profile In other words

04:59

the price is going up Mohr each time Interval This

05:03

might be the ultimate siren Call that a stock is

05:05

headed to unheard of heights and we want to own

05:08

it But lastly we might have a stock whose price

05:10

is dropping daily The mo mentum might also be increasing

05:13

In other words the price is dropping at a rate

05:16

more and more and more each time interval which might

05:19

mean we're headed for a berth on the Titanic Go

05:21

get your violent So how do we actually calculate the

05:25

mo mentum or speed at which the price is changing

05:28

Well almost every investing platform whether professional or for the

05:31

home investor like you and me does it for you

05:34

already But it can also be done by hand The

05:37

first process involves calculating the stochastic oscillator That's the percent

05:41

K thingy there which is a direct measure of stocks

05:44

Mo mentum the lowest low closing price and highest high

05:48

closing price are just what they sound like the lowest

05:50

lowest lowest closing price stock took on over our time

05:53

period typically a fourteen days We look at things here

05:56

the highest highs the highest closing price the same time

05:58

period Once we have a percent K for a bunch

06:01

of successive time periods we also need a simple well

06:03

three day moving average of percent Cave denoted by percent

06:06

D This moving average will take the first three values

06:09

of percent k and find their simple average And we'll

06:11

drop the first of the three percent K values and

06:13

add the first unused value of percent k next in

06:16

line and find a new average and so on Until

06:18

we've used all the percent K values what the two

06:21

sets of values percent Kane percent D are plotted on

06:24

the same graph checkout line graph of the bottom of

06:26

this chart and then we start interpreting Seriously though no

06:30

one does it by hand but we will well because

06:32

of the nature of how it's calculated The value of

06:34

K will always be between zero and one hundred So

06:36

certain way points between zero hundred become indicators of whether

06:39

a stock might either be over bottom or over Seoul

06:42

a stock that's over bots one that analysts believe that

06:45

for a variety of reasons is trading above its actual

06:48

value They believe it may be due for a downward

06:50

price correction at some point in the future Example a

06:53

company experiences a bump in stock price after a press

06:55

release saying they have a new hotshot CEO coming on

06:57

board to right the ship While the stock price may

07:00

rises people jump on board but may also auto correct

07:03

downward Once the company gets back to business as usual

07:06

a stock that is oversold is considered to be priced

07:09

below its actual value The price is probably likely then

07:13

to rebound upward in the opposite direction right But let's

07:15

say a report untruthfully link the company to human rights

07:19

violations in one of their overseas factories The stock price

07:22

might drop is an immediate overreaction Until the real story

07:25

comes out exonerating the company well At this point the

07:28

price would probably rebound right well Stocks that have a

07:31

percent K above eighty are considered overbought while stocks of

07:34

the percent K below twenty or considered oversold The actual

07:38

value percent K however isn't the only way we can

07:41

use to casting analysis help us track of stocks momentum

07:44

and also compare the values of percent k the stochastic

07:47

oscillator there in the present di the simple three day

07:49

moving average of percent K to gain other insights into

07:52

a stocks mojo When the two lines present Cade present

07:55

here plotted together they'll often be very close to each

07:57

other But time to percent K line will either dropped

08:00

down through the present the line or cross upwards through

08:03

the present deal A line When we have sent Kay

08:05

dropped down through the venti This is signaled that the

08:07

price may be on its way up When the percent

08:09

K line rises up through the present the line well

08:11

possibly signals a drop in price Or rather the odds

08:14

get higher based on these patterns Now because some of

08:17

us don't have the memories of elephants let's recap a

08:19

bit stochastic analysis and specifically the stochastic oscillator measure the

08:24

speed at which a value like the stock price is

08:26

changing Often called mo mentum the stochastic oscillator percent K

08:30

and a three day moving average plenty or typically calculated

08:33

for us and plotted over a period of days weeks

08:35

or even months when percent K gets above eighty the

08:38

stocks considered over bought and once below twenty it's considered

08:41

oversold Also the behavior of the percent came percent D

08:44

lines taking together can produce signals to either buy or

08:47

sell Remember it's not just about the trend in the

08:50

stock price itself It also matters what's going on inside

08:53

the stock in terms of the momentum of the price

08:55

And in a showdown of these trading patterns versus fundamental

08:58

activities in the company like how well or poorly business

09:01

is doing the latter always wins The latter always directs

09:05

the stock price over just these simple patterns that statistician's

09:08

like the point to to make up little games in

09:10

their heads So that's stochastic analysis so complicated A cave 00:09:14.162 --> [endTime] man can't do it you know Sorry there Aug

Full Transcript