The stochastic oscillator is one of the more prolific trading oscillators employed by traders. Though like all technical analysis tools, it has flaws, it's also proven to be a very effective trading tool when used skillfully.
What Is Stochastics?
Stochastics is a mathematical concept that has found a use in the trading world. Essentially, a stochastic oscillator is a plot that compares a stock's or index's current price to its price range over a previous number of days. The idea is simply that if a stock's current price is at the very upper or lower end of its recent price range, then it could be overbought or oversold, respectively. The former may be a reason to sell, while the latter may a reason to buy.
(Note the graphics below illustrate the use of the tool.)
Stochastics Formula
While knowledge of the stochastic formula is not necessary to use the tool, good traders should be familiar with the math of any indicators they choose to use. There are generally two lines plotted for a stochastic chart. One is called '%K', and the other is called '%D'.
The formula for %K is:
- %K = 100[(C - Ln)/(Hn - Ln)]
- C = the most recent closing price
- Ln = the low of the n previous trading sessions
- Hn = the highest price traded during the same n-day period.
%D is simply a moving average of %K. Visually, the %D line appears to 'follow' %K.
Charting software plots the %K and %D lines on a scale from 0 to 100 (or some from 0.00 to 1.00). Since each day that passes means a new set of 'n' days and a new closing price is created, both the %K and % D lines will change daily. The progress of those lines over time is indicative of a trend. However...
Putting Stochastics Into Practice
When the %K plot falls under a certain threshold (usually 20, though not always), the stock is considered 'oversold'. Conversely, when the %K line moves above a certain threshold (usually 80, though not always), the stock is considered to be 'overbought.' Superficially, that may be viewed as a reason to buy or sell a stock. Caution is advised though- stocks and indices can stay overbought and stay oversold for long periods of time, and continue to move in the 'wrong' direction the entire time.
As an alternative, traders may want to wait for the %K line (or both the %K and %D lines) to move back above the 'oversold' threshold to signal a new purchase. Likewise, traders may want to wait for %K and or %D to fall back under the 'overbought' threshold before selling or shorting a stock. Some traders choose to buy or sell when the %K line crosses the %D line. Though this can be effective, the technique may yield too many errant signals due to heightened daily volatility.
Also, don't assume the stochastic oscillator has to be used alone; it can be used in conjunction with other trading indicators.
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- Using the MACD Indicator
- Review of Schwab's StreetSmart Pro Platform
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