The Stochastics oscillator can provide alerts to traders regarding potential trend reversals and/or potential breakouts during sideways trends. Some traders also use Stochastics as a confirmation tool in assessing bullish and bearish trends. In simple terms, Stochastics measure the strength or weakness of a given stock or asset by comparing where it’s current price stands in relation to its overall price range over a given time period.
Stochastics is most commonly thought of as an oscillator, because it fluctuates up and down within a bounded range of values. On a price chart, Stochastics is typically plotted using two separate lines referred to as the %K line and the %D line.
• %K line - is the faster line and will reach overbought or oversold levels more quickly as it is more sensitive to price movements.
• %D line - is the moving average of the %K line. As a result the %D line is a smoother line that moves more slowly than the K% line and is less sensitive to the volatility of "overbought" or "oversold" conditions.
The %K line sets the pace for oscillator movement, while the %D line is simply a moving average of that movement.
Indicator Signals: What Traders Look for
Overbought/Oversold (Trend Exhaustion)
Both the %K line and the %D line fluctuate in range between 0% and 100%. As price declines and spends more time near its recent lows, these lines trend towards 0%. On the other hand as price rises and spends more time near it recent highs, these lines trend toward 100%. The more extreme the values, the more "overbought" or "oversold" the stock or asset is considered to be. For most traders:
• The upper range above 80% indicates overbought conditions
• The lower range below 20% indicates oversold conditions
Probably the most common way this indicator is used by traders is simply to wait for the %K line and/or the %D line to reach an overbought or oversold region and then reverse. This action alerts traders to the fact that the speed and momentum of the trend may be changing and that investor sentiment may be reversing. These simple reversals can be more useful during a neutral, sideways or trendless market rather than in the face of a strongly trending market.
The key thing to remember is that a simple reversal by Stochastics does not necessarily signal that a price reversal is imminent, only that the possibility exists. As with any technical analysis signal, it’s important to wait for confirmation of a change in trend before taking action.
Directional Trending (Trend Confirmation)
In assessing the trend of a given stock or other asset, many traders will consider the current trend for the %K line and %D line. If a price advance is accompanied by a rising %K line and a rising %D line and the %K line is above the %D line, the Stochastics is said to be confirming the uptrend. Likewise, if a price decline is accompanied by a declining %K line and a declining %D line and the %K line is below the %D line, then Stochastics is said to be confirming the downtrend.
Bullish Oversold Signal (Trend Exhaustion)
A bullish oversold signal occurs when the %K line and/or %D line falls to an oversold level (20% or less), and then rises above it, generating a signal that bullish sentiment is potentially gaining momentum.
Bullish Trend Signal (Trend Confirmation)
A bullish trend signal is considered to be in force when the %K line and the %D line are rising and the %K line is above the %D line.
Bearish Overbought Signal (Trend Exhaustion)
Bearish overbought signals occur when the %K line and/or %D line rises to an overbought level (80%), and then falls below it, generating a signal that bearish sentiment is potentially gaining momentum.
Bearish Trend Signal (Trend Confirmation)
A bearish trend signal is considered to be in force when the %K line and the %D line are falling and the %K line is below the %D line.
In a trendless, sideways market, simple stochastic reversals that occur within the overbought or oversold regions can be effective at highlighting potential price turning points. In a trending market, simple reversals can be less effective, so traders should look for further confirmation by monitoring price and volume action or by using other indicators before assuming that an existing trend has in fact reversed.
Also, in a trending market, a bullish trend signal or bearish trend signal can lend further weight of evidence that the price trend is valid.