If you have been looking at stock charts for some time, you are probably familiar with the stochastic indicator. It is one of the most popular momentum indicators applied to charts and is widely used. But, even experienced traders may not fully understand what the indicator does.
Stochastics is an indicator that has withstood the test of time. According to market historians, this indicator was believed to be developed by a market technician named George Lane although there is some question as to whether or not it was the effort of any single individual.
What is known is that Lane popularized the indicator. He travelled widely and explained how to trade with stochastics, putting the indicator on the chart, to speak, for many traders. The chart below shows stochastics consists of two lines at the bottom of the chart.
Lane explained that, “Stochastics measures the momentum of price. If you visualize a rocket going up in the air – before it can turn down, it must slow down. Momentum always changes direction before price.”
The same idea applies to a baseball, which many of us are more familiar with. The baseball, at least in Major League Baseball, often flies off the bat and arcs higher. At some point, the ball levels off and as it does its momentum slows. Then, it begins to fall, and its momentum accelerates to the downside.
Stochastics, and other momentum indicators, apply this idea to prices. The stochastics calculation is an effort to quantify this behavior.
Technical analysts generally believe that a close near the high for the day is bullish and a close near the low is bearish. Stochastics quantifies this belief with the formulas shown below that define the two lines of the indicator.
The indicator consists of two lines. One is fast (%K) and the other is slow (%D). The calculation is, of course, done for us at many free web sites including StockCharts.com and TradingView.com. At those sites, there are often lines added to show when the indicator is overbought or oversold.
Overbought levels are unusually high readings of the indicator. This indicates high because the stock is being bought quickly or overbought by traders. Oversold readings are unusually low and indicate a high level of selling.
Because of the way it is calculated, the indicator will always have a value between 0 and 100. It will oscillate around 50, the midpoint. The fact that it is bounded within a range allows us to create rules defining when we should expect a reversal.
Finding Buy and Sell Levels for Stochastics
In the chart above, %K is shown in blue and %D is shown in magenta. The first way to trade stochastics is the same way that a moving average would be interpreted.
When the slow line is above the fast line, the trend is up. In the chart above that is shown with the blue line above the magenta line. This is similar to a moving average crossover strategy.
For a moving average strategy, the buy signal is given when the price moves above the moving average. In this case, the fast line is price and the slow line is the moving average.
Likewise, when the fast line falls below the slow line, the trend is down. This is also similar to the price and the moving average where a sell signal is given when the price (the fast line) falls below the moving average (the slow line).
Crossovers are just one way that stochastics can be used. The indicator also identifies potential trend reversals when it becomes overbought or oversold.
As noted, an overbought condition exists when momentum has moved up too fast and an oversold extreme occurs when momentum falls too fast.
In the chart above, extremes are marked with solid grey lines. The oversold level for stochastics is usually set at 20. This indicates that prices have fallen and the close is near the low. A reading below 20 is believed to indicate a rally in prices is imminent.
Overbought is generally defined as any reading above 80. The idea is that prices are due to decline when the indicator moves above 80.
The next chart adds lines showing some overbought and oversold signals. Buy signals are marked with solid green lines and sell signals are shown with solid red lines.
In some cases, the signals worked well while in other cases the signals were early. When a signal is early it could be costly to act since the price can move quickly after becoming overbought or oversold.
To avoid early signals, some traders wait for the indicator to reverse. So, for a sell signal, they would consider a move above 80 in the indicator to be a warning that the time to sell is near. They would then sell when stochastics falls back below.
In a similar way, a move below 20 on the indicator is telling the trader that the decline is near an end and the buy signal is triggered when the indicator moves back above 20.
Delaying the action will not result in trades that are winners 100% of the time. No signal will ever be right all of the time. But, stochastics is an indicator that can provide signals that could potentially be profitable when followed with discipline for the long run.
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