The stochastic indicator can help determine when a market
is overbought or oversold.
The stochastic indicator is:
- a momentum oscillator that can warn of strength or weakness in the
market, often well ahead of the final turning point.
- based on the assumption that when a stock is rising it tends to close
near the high and when a stock is falling it tends to close near its lows.
The original stochastic oscillator, developed by Dr. George
Lane, is plotted as two lines called %K, a fast line and %D, a slow line.
%K line is more sensitive than %D
%D line is a moving average of %K.
%D line triggers the trading signals.
Although this sounds complex, it is similar to the plotting of
moving averages. Think of %K as a fast moving average and %D
as a slow moving average. The lines are plotted on a 1 to
100-scale. "Trigger" lines are normally drawn on stochastics charts at the 80%
and 20% levels. A signal is generated when these lines are crossed. The zones
above and below these two lines can be referred to as the stochastic bands.
The original stochastic is sometimes referred to as the "fast"
stochastic to differentiate it from the "slow" stochastic. Some traders feel
the fast stochastic %K line is too sensitive and, to improve their analysis,
they replace the original %D line with a new slow %K line. The new slow %D
line formula is then calculated from the new %K line. The result is a pair of
smoothed oscillators that some traders believe provide more accurate signals.
The 80% value is used as an overbought warning signal, and the
20% is used as an oversold warning signal. The signals are most reliable if
you wait until the %K and %D lines turn upward below 5% before buying, and the
lines turn downward above 95% before selling.
An overbought or oversold level indicates that a market may be
vulnerable to a retracement
The Stochastic Oscillator generates signals in three main
Extreme values when the 20% and 80% trigger lines are crossed. Buy
when the stochastic falls below 20% and then rises above that level. Sell
when the stochastic rises above 80% and then falls below that level.
The pattern of the stochastic is also important; when it stays below
40-50% for a period and then swings above, the market is shifting from
overbought and offering a buy signal. And vice versa when it stays above
50-60% for a period of time.
Crossovers between the %D and %K lines. Buy when the %K line rises
above the %D line and sell when the %K line falls below the %D line.
Beware of short-term crossovers. The preferred crossover is when the %K
line intersects after the peak of the %D line (right-hand
crossover). Crossovers often provide choppy signals that need to be
filtered through the use of other indicators.
Divergences between the stochastic and the underlying price. For
example, if prices are making a series of new highs and the stochastic is
trending lower, you may have a warning signal of weakness in the market.