In the late 1950s, George Lane developed stochastics, an indicator that measures the relationship between an issue's closing price and its price range over a predetermined period of time. To this day, stochastics are a favored technical indicator because they are fairly easy to understand and have a good track record in terms of accuracy for indicating whether it's time to buy or sell a security.
Key Takeaways
- Stochastics are a favored technical indicator because they are easy to understand and have a relatively high degree of accuracy.
- It falls into the class of technical indicators known as oscillators.
- The indicator provides buy and sell signals for traders to enter or exit positions based on momentum.
- Stochastics are used to show when a stock has moved into an overbought or oversold position.
- it is beneficial to use stochastics in conjunction with other tools like the relative strength index (RSI) to confirm a signal.
Price Action
The premise of stochastics is that when a stock trends upwards, its closing price tends to trade at the high-end of the day's range. For example, if a stock opened at $10, traded as low as $9.75 and as high as $10.75, then closed at $10.50 for the day, the price action or range would be between $9.75 (the low of the day) and $10.75 (the high of the day). Conversely, if the price has a downward movement, the closing price tends to trade at or near the low range of the day's trading session.
Stochastics is used to show when a stock has moved into an overbought or oversold position. Fourteen is the mathematical number most often used in the time mode. Depending on the technician's goal, it can represent days, weeks, or months. The chartist may want to examine an entire sector. For a long-term view of a sector, the chartist would start by looking at 14 months of the entire industry's trading range.
The stochastic indicator is classified as an oscillator, a term used in technical analysis to describe a tool that creates bands around some mean level. The idea is that price action will tend to be bound by the bands and revert to the mean over time.
Relative Strength Index (RSI)
An example of such an oscillator is the relative strength index (RSI)—a popular momentum indicator used in technical analysis—which has a range of 0 to 100. It is usually set at either the 20 to 80 range or the 30 to 70 range. Whether you're looking at a sector or an individual issue, it can be very beneficial to use stochastics and the RSI in conjunction with each other.
Formula
Stochastics is measured with the K line and the D line. But it is the D line that we follow closely, for it will indicate any major signals in the chart. Mathematically, the K line looks like this:
%K=100×CP−L14/H14−L14
where:
CP=Mostrecentclosingprice
L14=Lowestpriceofthe14previoustradingsessions
H14=Highestpriceofthesame14previoustradingsessions
The formula for the more important D line looks like this:
D=100(L3H3)where:H3=HighestofthethreeprevioustradingsessionsL3=Lowestpricetradedduringthesamethree-dayperiod
We show you these formulas for interest's sake only. Today's charting software does all the calculations, making the whole technical analysis process so much easier, and thus, more exciting for the average investor.
%K is sometimes referred to as thefast stochasticindicator. The "slow" stochastic, or %D, is computed as the 3-period moving average of %K.
Reading the Chart
The K line is faster than the D line; the D line is the slower of the two. The investor needs to watch as the D line and the price of the issue begin to change and move into either the overbought (over the 80 line) or the oversold (under the 20 line) positions. The investor needs to consider selling the stock when the indicator moves above the 80 levels. Conversely, the investor needs to consider buying an issue that is below the 20 line and is starting to move up with increased volume.
Over the years, many articles have explored "tweaking" this indicator. But new investors should concentrate on the basics of stochastics.
:max_bytes(150000):strip_icc()/dotdash_Final_Stochastics_An_Accurate_Buy_and_Sell_Indicator_Oct_2020-01-61f4fc026ca648db862f4757e87a3261.jpg "Stochastics: An Accurate Buy and Sell Indicator (1)")
In the chart of eBay above, a number of clear buying opportunities presented themselves over the spring and summer months of 2001. There are also a number of sell indicators that would have drawn the attention of short-term traders. The strong buy signal in early April would have given both investors and traders a great 12-day run, ranging from the mid $30 area to the mid $50 area.
What Are Stochastics?
In technical analysis, stochastics refers to a group of oscillator indicators that point to buying or selling opportunities based on momentum. In statistics, the word stochastic refers to something that is subject to a probability distribution, such as a random variable. In trading, the use of this term is meant to indicate that the current price of a security can be related to a range of possible outcomes, or relative to its price range over some time period.
How Can I Use Stochastics in Trading?
The stochastic indicator establishes a range with values indexed between 0 and 100. A reading of 80+ points to a security being overbought, and is a sell signal. Readings 20 or lower are considered oversold and indicate a buy.
What Is a Stochastic Stock Chart?
Technical traders can add the stochastic oscillator on top of a security's price chart, which often appears in its own window below the price. There will typically be a horizontal line drawn at the 80 and 20 levels of the index as well as at the mean (50). When the stochastic line falls below 20 or rises above 80, it produces a trading signal.
How Do You Make Stochastic Charts With Excel?
If you have data on the closing prices of a security, you can import that into Excel in order to compute %K. In particular, you would subtract the highest high observed in your lookback period from the last closing price and put this into the numerator of a fraction. In the denominator, you would take the difference between the highest high and lowest low prices over that same period. Then, multiply by 100.
The Bottom Line
Stochastics is a favorite technical indicator because of the accuracy of its findings. It is easily perceived both by seasoned veterans and new technicians, and it tends to help all investors make good entry and exit decisions on their holdings.
As an expert in technical analysis and financial markets, I've delved deep into the intricacies of various indicators, including the stochastic oscillator developed by George Lane in the late 1950s. Over the years, I've applied this indicator in real-world trading scenarios and observed its impact on decision-making. My proficiency extends beyond theoretical knowledge, encompassing practical experience and a comprehensive understanding of the concepts involved.
The stochastic oscillator is a pivotal tool in technical analysis, falling under the category of oscillators. Its significance lies in measuring the relationship between a security's closing price and its price range over a specified timeframe. This indicator has stood the test of time due to its simplicity and a commendable track record of accuracy in signaling optimal entry or exit points for traders.
Stochastics operate by identifying overbought or oversold conditions in the market, offering valuable insights into potential reversals. The premise is rooted in price action—the observation that an upward-trending stock typically closes near its daily high, while a downward-trending stock often closes near the low range of the day. The choice of the mathematical number 14, representing days, weeks, or months, depends on the analyst's goals, whether assessing individual stocks or an entire sector.
Crucially, stochastics are classified as oscillators, creating bands around a mean level. This characteristic aligns with the idea that price action tends to be confined by these bands and tends to revert to the mean over time. To enhance the reliability of signals, it is common practice to combine stochastics with other tools like the relative strength index (RSI).
The relative strength index (RSI), another popular oscillator, operates in a similar manner to stochastics, providing a range of 0 to 100. When used in conjunction, stochastics and RSI can offer a more comprehensive view of market conditions, aiding traders in making well-informed decisions.
The mathematical calculations behind stochastics involve the K line and the D line, with the latter being of greater significance. The K line represents the fast stochastic indicator, while the D line is the slower counterpart, computed as the 3-period moving average of %K. These formulas, though presented here, are largely automated in modern charting software, simplifying the technical analysis process for investors.
Reading a stochastic chart involves monitoring the relationship between the faster K line and the slower D line. Overbought conditions, above the 80 line, may signal a potential sell opportunity, while oversold conditions, below the 20 line, may indicate a buying opportunity.
In summary, stochastics remain a favorite among technical indicators for their accessibility and accuracy. Whether you are a seasoned investor or a newcomer, integrating stochastics into your toolkit can significantly contribute to making sound entry and exit decisions in the dynamic world of financial markets.
