Upbeat music plays throughout.
Narrator: The stochastic indicator is a technical analysis tool that helps traders see when a stock might change direction. The stochastic measures a stock's momentum, or how quickly its price is changing, and charts it in a range to identify extreme values. These extreme values are called reversal zones, and may suggest that a security is overbought or oversold. That could mean the stock is ready to reverse direction, which could be a bullish or bearish signal. I'll show you how to set up and use the stochastic indicator on the thinkorswim® desktop platform.
Animation: M S F T is entered in the symbol box.
Narrator: Let's begin by adding the indicator to a chart. I'm going to pull up Microsoft (MSFT). Then, I'll go to the Studies menu, and choose the stochastic. Notice that there are a few to choose from. You can go to the thinkorswim Learning Center to learn more about these versions. Today, we're going to focus on the StochasticFull indicator because it's more general.
There are two lines that make up the stochastic indicator: %K in red and %D in pink. A point on the %K line is calculated by comparing the recent closing price to its range over the last 10 days. The %D is the more important line because it's the signal line. The %D line is a three-day simple moving average of the %K line, which is why it's less volatile.
The stochastic is charted on a scale of 0 to 100. The reversal zones are at 80 and 20. When the signal line is above 80, it suggests that the security is overbought, meaning that the price has risen to a point that it could drop. When it's below 20, the security is oversold suggesting the price may rally.
Animation: P L T R is entered into the symbol box. Then K S S is entered.
Narrator: Despite these definitions, a stock can remain overbought or oversold for a long time. Back in 2024, Palantir (PLTR) traded in or near the overbought zone from September to December, while Kohls (KSS) was in the lower reversal zone much of November through January.
Like most oscillators, the stochastic tends to do best when the security is in a sideways trend. Let's go back to Microsoft. There are a number of ways to trade the stochastic; we're just going to focus on a couple.
Animation: Bullish signals are highlighted in April, August, October, and January.
Narrator: A bullish signal occurs when the signal line moves above 20. We see on the chart that the stochastic was oversold four times. Each time it moved back out of the oversold area, it could've been a buy signal.
Animation: Bearish signals are highlighted in May, July, September, and December.
Narrator: A bearish signal occurs when the signal line moves below 80. The signal line was in the overbought area four times. Each time it fell out of the overbought zone, a trader might consider it a bearish signal.
One hypothetical trade could've happened on October 16. The signal line crossed above 20 and a trader could have bought shares around $416. Then they could've exited the trade on December 23 at approximately $435. Like other oscillators, the stochastic won't get you out at the very top or bottom.
Animation: C A G is entered in the symbol box.
Narrator: But not every signal develops. Look at Conagra (CAG), which had a bullish signal on November 27. However, if a trader took that signal it could've resulted in a loss because the sideways trade broke down.
Another common signal is a hinge. Hinges can be effective with stocks that are trending up or down but they're more subjective. A hinge occurs when the signal line changes direction between the reversal zones.
Animation: O K L O is entered in the symbol box.
Narrator: For example, OKLO's (OKLO) stochastic turned lower the first part of January. However, later that month, it turned higher, creating a hinge that preceded a bullish rally. Some traders only trade bullish hinges on bullish stocks and bearish hinges on bearish stocks.
Animation: G H M is entered in the symbol box.
Narrator: Of course, not every hinge signal works out. Graham Corp. (GHM) experienced back-to-back hinges. The stock started higher, but the rally failed after a disappointing earnings report.
Animation: Edit Studies is selected and the SimpleMovingAvg is selected. The period for the moving average changes from 9 to 10.
Narrator: To help confirm signals, many traders try to pair the stochastic with another indicator like candlestick patterns or a moving average. For example, adding a 10-day simple moving average may have helped to confirm potential buy and sell signals on Deere (DE). In October, the stochastic gave a bullish hinge, but the price failed to move away from the moving average. However, the second hinge in November saw a stronger break above the moving average that coincided with the stochastic signal.
These pairings should be part of a broader trading plan where you determine when to buy and sell and how many shares you'll trade. A plan can be vital to a technician's success. Also, consider testing the stochastic signals in paperMoney® as you learn the ins and outs of this indicator.
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