This article will discuss the stochastic indicator and how best to use it, and when not to use it.
What is the Stochastics Stock Market Indicator
Created by George C. Lane in the late 1950s, this gained popular appeal through its ability to show if a stock is overbought or oversold visibly. Stochastics is an oscillating indicator which means it oscillates between the 0 and 100 marks.
Stochastics Stock Market Indicator Example
- Stock is Overbought: the line is above the 80 mark – a stock price is at the upper range of its movement and could be due for a downturn.
- Stock is Oversold: the line is below the 20 mark – a stock price is oversold and may be due for an upturn in its price movement.
There are two main types of setting, the Fast Stochastic and the Slow Stochastic.
- Fast Stochastics: use shorter Time Periods and Shorter Averages – this creates more fluctuations but conversely also more false alarms
- Slow Stochastics: use longer time periods and longer average periods – this creates a smoother flow and gives the ability to see trends clearer; the drawback is the Indicator lags price and is less responsive.
Problems with the Stochastics Indicator
Please be careful with this indicator; the following points must be understood when using stochastic indicators.
Using Slow Stochastics settings on most stock charting packages does not provide enough information, whether trading intraday or on a longer timeframe.
In my opinion, Stochastics works well in a short time frame to save you a few points on your buy and sell price, but not much more.
Stochastics work best when there are no strong fluctuations or volatility in the market or a particular stock.
Always use Stochastics with other indicators, not alone. Stochastics use the Price Open, High, Low, and Close for the period, so they can be used well in conjunction with the Relative Strength Indicator (RSI), which uses only Close Price as the input.
Backtest a stochastic setting to see if it fits the past. Adjust the Values to fit the stock.
If it does not tell you anything, do not use it.
How to use Stochastics – 4 Point Analysis
In this example, you can see Smith & Wesson Holdings Corp, the gunmaker.
Notes on the chart:
Point 1: November to February, the highest highs of the stock are slowly declining
Point 2: Fast Stochastics Settings (14,8,8) are showing a slight divergence, but also a lot of false alerts.
Point 3: Slow Stochastics (34, 8, and 8) show much smoother lines and stronger divergence where the stock for this whole period does not reach an oversold state.
Point 4: Moving Averages (10 & 20) did an excellent job indicating when the ideal time to buy was. Thus using Stochastics with other indicators is important.
If you like to use Stochastics, use them with care. Follow the guidelines above and use them with other indicators.
Divergences are your friends with practically all indicators.
Remember, when an indicator starts to Diverge with the Trend of the price, this is an early warning signal that the underlying factors behind a stock price are changing, and it may not be visible in the price pattern.