A Stochastic indicator uses a simple formula to measure where stocks are currently trading, on the right track towards trending up or down.
Stochastic is one of the most popular technical indicators for traders because it gives them insights into both short-term and long-term trends.
It was created by George C. Lane in the late 1950s, who worked as an engineer at Boeing Aircraft Co.
Stochastic isn’t based on complex mathematics; instead, it’s constructed from two moving averages, which are lines that represent average price levels over certain periods.
To calculate one of these averages, each closing price is added to an accumulating total; then, the number is divided by the total number of prices used for the calculation.
The full name of the Stochastic indicator is the “Stochastic Oscillator.”
There are two types of Stochastics, each with its own set of parameters.
One type uses a 14-period simple moving average for its calculation; this version is also known as Smoothed Moving Average (SMA), %K and Slow Stochastic. The other type, which uses a 5-period SMA, is known as Fast Stochastic or %D.
The Slow Stochastic formula calculates the reading on the chart by averaging the high, low, close & previous values over 14 periods.
This results in a smoothed view of where stocks have traded over time. It helps eliminate wild price swings and helps identify where stocks are trending.
When the Slow Stochastic is oversold, the stock may be a good candidate for purchase; conversely, investors should maybe look elsewhere for more prospective opportunities when it’s overbought.
The Fast Stochastic simply divides %K by %D instead of 14. This results in a faster response to price changes and a smaller range between readings.
Because it offers a faster view of short-term trends, most technical analysts prefer using this version.
Percentage K, or “% K”, is calculated using the moving average. Percentage D or “%D” is taken from the Fast Stochastic, which has been divided by two (%D).
The Fast Stochastic also takes the three days’ simple moving averages of itself before being multiplied by 100 to give it a percentage reading.
A positive reading indicates that prices are above the moving averages, while a negative one means they are below.
As with all indicators, readings above 70 indicate an overbought condition and those below 30 express oversold conditions.
How you make use of the Slow Stochastic is really up to you, but here are several basic ways traders can benefit from it.
Identify stocks that show strong trends.
The best way to do this is by looking for moves above or below an 18-day moving average.
If a stock stays above its moving average for at least ten days, then it’s trending up; if it does so for eight days below its moving average, then it’s trending down.
When a stock breaks out of that trend and begins making lower lows and lower highs, try stepping aside and waiting for the downtrend to end.
Watch for Stochastic signals.
The most basic of these is divergence, where the indicator makes a lower low or high than the stock does.
This shows that momentum is slowing or that prices are going further down without confirming with the indicator.
That’s classic bearish divergence, and it tells you it’s time to go short. A bullish divergence occurs when prices fall, but the Slow Stochastic doesn’t confirm them by making a lower low or a trough below its previous one.
Those who did get in on a long trade should be watching the price action at support levels for confirmations from the indicator. It should be trading higher along with their positions.
A divergence signal serves as the best confirmation to anticipate a return back up to resistance levels.
When the Slow Stochastic moves above 80, this indicates that the stock is in overbought territory.
While this may sound like a bad thing, it’s not always exactly true; in fact, some experts say this area shows higher prices are coming (and vice versa when the indicator falls below 20).
If you think about it, if stocks continue trading above their averages, then they’re building up energy for another leg up.
That’s why many technical analysts recommend buying when an asset crosses into or through its upper Bollinger Band at high readings of the Slow Stochastic.