Background: The stochastics indicator is often associated with George Lane of Investment Educators, who developed specific rules to make stochastics an effective indicator.

The premise of stochastics is rather simple. When prices are moving up, closes will tend to be near the top of the price range for a given period. Then, as the market nears a top, closes will slip back from the top of the range, suggesting a loss of momentum. Similarly, when prices are moving lower, closes will tend to congregate near the lower end of the price range for a given period. Then the downward pressure diminishes, indicating a loss of momentum.

Purpose: Stochastics is intended to be an indicator that reflects changes in momentum, either up or down. It does not give specific prices but only offers clues on price direction. Although the premise of stochastics seems plain enough, its computation is more complex and best left to analytical software.

The clues are provided by the interaction of two lines. %K, the more sensitive line, determines where the current close is relative to the price range for a given time, typically 14 periods. %K is a percentage figure to show where the close is within the total price range for the selected period.

%D is a three-period moving average of %K in the fast stochastics version or another three-period moving average of %D arrive at a smoother, slow stochastics version favored by most traders who use this indicator.

Basic signals: Stochastics produces several different trading signals:

  • Extreme readings in %K and %D. In general, a reading above 80, the dashed green line on the chart below, indicates an overbought situation and a potential turn down. A reading below 20, the dashed red line on the chart, indicates an oversold condition and a potential turn to the upside. A reading of 0 does not mean a price bottom but extreme weakness in prices
  • Crossovers of %K and %D when the two readings are in the overbought (80-plus) or oversold (20 and below) zones. Sometimes the turn may not occur until after a second crossover. The arrows on the chart below show several situations where the crossovers led to timely buy or sell signals as a new trend was beginning.
  • Divergence between the indicator and price action – that is, prices make a higher high but the indicator makes a lower high or prices make a lower low but the stochastics lines make a higher low. The solid black lines on the chart are examples of divergence at a low and at a high. Divergence is one of the most useful signals for a number of indicators, not just stochastics.

Pros/cons: Stochastics signals look very good on charts for markets that are moving sideways or churning. However, in strong trending situations, they continue to have the same reading for a number of periods and do not provide any useful trading signals, such as during the sideways period circled on the chart below.

Stochastics can illustrate whether the high or low was made with as much momentum as a prior high or low, but they cannot predict how long or how much further prices might go once they reach an upper or lower threshold.

As is the case with many indicators, a trader needs to use stochastics with other indicators and in the context of market conditions revealed by chart patterns. In other words, it takes some experience with stochastics to understand when and how to make the best use of its signals.

Stochastics Indicator