Stochastics: An Accurate Buy and Sell Indicator

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.

Fourteen is the mathematical number 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.

Stochastics is a favored technical indicator because it is easy to understand and has a high degree of accuracy. It is used to show when a stock has moved into an overbought or oversold position.

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 or price action. Price action refers to the range of prices at which a stock trades throughout the daily session. 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.

Jack D. Schwager, the co-founder of Fund Seeder and author of several books on technical analysis, uses the term "normalized" to describe stochastic oscillators that have predetermined boundaries, both on the high and low sides. 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.

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:

$\begin{aligned} &\text{K} = 100 \left [ (\text{C} - \text{L5}\textit{close})\div (\text{H5} - \text{L5})\right] \\ &\textbf{where:} \\ &\text{C} = \text{the most recent closing price}\\ &\text{L5} = \text{the low of the five previous trading sessions}\\ &\text{H5} = \text{the highest price traded during the same five-day period}\\ \end{aligned}$​K=100[(C−L5close)÷(H5−L5)]where:C=the most recent closing priceL5=the low of the five previous trading sessionsH5=the highest price traded during the same five-day period​

The formula for the more important D line looks like this:

$\begin{aligned} &\text{D} = 100(H3 \div L3) \\ &\textbf{where:} \\ &H3 = \text{the highest of the three previous trading sessions}\\ &L3 = \text{the lowest price traded during the same three-day period}\\ \end{aligned}$​D=100(H3÷L3)where:H3=the highest of the three previous trading sessionsL3=the lowest price traded during the same three-day period​

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.

The K line is faster than the D line—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 level. 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.

Source: TradeStation

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.

Stochastics is a favorite indicator of some technicians 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. (For more insight, read "Exploring Oscillators and Indicators: Stochastic Oscillator.")