Stochastic Modeling

Finance Allah Shmoop What is Stochastic analysis Stochastic analysis is

a method of determining the rate at which the value

of a random variable like the price of a stock

is changing But obviously we contract the price of a

stock like every trading platform ever devised Contract the closing

prices of the stock and plot um for us But

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

and reaching some arbitrary price point And then you know

selling or buying based on what some crystal ball tells

you to do What about the speed at which the

price is changing Dirt inks Stock has been rising pretty

steadily over the last six trading days since they announced

a breakthrough in their dirt production process which has led

to tons of investors Jumping on board Is buyers driving

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

demand than supply You want to hit your wagon to

the gravy train But what if the price gains are

slowing In other words the price is still increasing but

increasing by less and less each day indicating that the

stock is possibly reaching a maximum value before Oh no

then maybe a correcting downward If we could also measure

the rate at which the prices air changing Well we

might be able to predict when or if the price

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

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

the pressure gets to be too much for you and

you take off the stranding your former friends Now what

if we not only track the speed of your car

but also the rate at which the speed is changing

Your car still might be speeding up from fifty miles

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

speeding up at a slower and slower rate But the

decreasing rate at which the speed is changing indicates that

you the driver might be reaching a top speed Soon

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

Nor is it a guarantee in forecasting future movements So

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

in the rate of change of stock price can often

precede the stock price reaching a high point or a

low point or even topping out and then dropping or

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

random Well stochastic analysis is a great way to forecast

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

of the stock Not just that the actual performance of

the stock but at the rate at which that performance

is changing kind of helps investors attach odds of a

stock going up and hitting some point or going down

hitting some other bad point And they can actually then

make bets that kind of reflect the odds or what

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

look at the way the stock looks in the mirror

but also look at it inner workings like an X

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

of closing price is plotted over time What we see

in the stochastic analysis X ray machine is a measure

of the rate at which those prices are changing So

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

does measuring the mo mentum of the stock help us

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

big fat growth mojo company Facebook For a time the

closing prices of Facebook were closing higher and higher values

each day from left to right across this timeline we

see that the prices in general continually closing at higher

and higher values But if we examine the growth we

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

the first half of this plot well we can see

the price increases from one seventy knew about one seventy

eight a difference of eight bucks Check out the middle

of the graph about three quarters the way across there

the price started one seventy eight The middle went upto

one eighty three a difference of five bucks While the

price is still increasing but not as fast it went

up fewer dollars in less time than the first time

right from three quarters of the way to the end

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

that about three quarters the way along the plot we

were at price of one eighty three And crossing that

final quarter on Lee showed growth of another in to

wish bucks right Well the rate at which the prices

are climbing is slowing clearly In other words the moment

um of the stock price is decreasing from what it

was at the far left Over here we can mash

the accelerator the floor and our speed goes up very

quickly Or we can use a light touch on the

gas pedal and increase our speed slowly The first case

our speed has large momentum In the second case our

speed has little mo mentum There are four obvious patterns

related to a stocks mojo which are calculated using stochastic

analysis that we should be aware of There are other

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

going to skip him for now But stocks price could

be climbing from day to day but the momento of

the stock could be decreasing In other words the rate

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

indicate that the price is going to reach a peak

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

decreasing and the mo mentum of the stock also decreasing

In other words the rate of the decline is slowing

down This might be a clue that the price will

bottom out soon rebound and start to increase again again

with the word might here being the key words No

guarantee ever particularly in stock picking We could have a

stock with a continually increasing price profile This stock could

also have an increasing MO mentum profile In other words

the price is going up Mohr each time Interval This

might be the ultimate siren Call that a stock is

headed to unheard of heights and we want to own

it But lastly we might have a stock whose price

is dropping daily The mo mentum might also be increasing

In other words the price is dropping at a rate

more and more and more each time interval which might

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

get your violent So how do we actually calculate the

mo mentum or speed at which the price is changing

Well almost every investing platform whether professional or for the

home investor like you and me does it for you

already But it can also be done by hand The

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

K thingy there which is a direct measure of stocks

Mo mentum the lowest low closing price and highest high

closing price are just what they sound like the lowest

lowest lowest closing price stock took on over our time

period typically a fourteen days We look at things here

the highest highs the highest closing price the same time

period Once we have a percent K for a bunch

of successive time periods we also need a simple well

three day moving average of percent Cave denoted by percent

D This moving average will take the first three values

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

drop the first of the three percent K values and

add the first unused value of percent k next in

line and find a new average and so on Until

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

sets of values percent Kane percent D are plotted on

the same graph checkout line graph of the bottom of

this chart and then we start interpreting Seriously though no

one does it by hand but we will well because

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

K will always be between zero and one hundred So

certain way points between zero hundred become indicators of whether

a stock might either be over bottom or over Seoul

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

for a variety of reasons is trading above its actual

value They believe it may be due for a downward

price correction at some point in the future Example a

company experiences a bump in stock price after a press

release saying they have a new hotshot CEO coming on

board to right the ship While the stock price may

rises people jump on board but may also auto correct

downward Once the company gets back to business as usual

a stock that is oversold is considered to be priced

below its actual value The price is probably likely then

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

say a report untruthfully link the company to human rights

violations in one of their overseas factories The stock price

might drop is an immediate overreaction Until the real story

comes out exonerating the company well At this point the

price would probably rebound right well Stocks that have a

percent K above eighty are considered overbought while stocks of

the percent K below twenty or considered oversold The actual

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

use to casting analysis help us track of stocks momentum

and also compare the values of percent k the stochastic

oscillator there in the present di the simple three day

moving average of percent K to gain other insights into

a stocks mojo When the two lines present Cade present

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

other But time to percent K line will either dropped

down through the present the line or cross upwards through

the present deal A line When we have sent Kay

dropped down through the venti This is signaled that the

price may be on its way up When the percent

K line rises up through the present the line well

possibly signals a drop in price Or rather the odds

get higher based on these patterns Now because some of

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

bit stochastic analysis and specifically the stochastic oscillator measure the

speed at which a value like the stock price is

changing Often called mo mentum the stochastic oscillator percent K

and a three day moving average plenty or typically calculated

for us and plotted over a period of days weeks

or even months when percent K gets above eighty the

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

oversold Also the behavior of the percent came percent D

lines taking together can produce signals to either buy or

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

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

the stock in terms of the momentum of the price

And in a showdown of these trading patterns versus fundamental

activities in the company like how well or poorly business

is doing the latter always wins The latter always directs

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

like the point to to make up little games in

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