Stochastics: An Accurate Buy And Sell Indicator

By Investopedia Staff AAA

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 model, and it can, depending on the technician's goal, 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. (For more insight on chart reading, see Charting Your Way To Better Returns.)

Price Action
The premise of stochastics holds that a stock's closing price tends to trade at the high end of the day's price action. Price action is the prices at which a stock traded throughout the daily session. The stock may have opened at $10.00, traded as low as $9.75 and as high as $10.75, and closed at $10.50 for the day. The price action of this example is between $9.75 (the low of the day) and $10.75 (the high of the day). If the issue, however, is currently in a downtrend cycle, the closing prices will tend to close at or near the low of the trading session.

Jack D. Schwager, the CEO of Wizard Trading and author of some the best books written 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) which has a range of 0-100, and are set at either the 20-80 range or the 30-70 range. Whether your looking at a sector or an individual issue, it can be very beneficial to use stochastics and the RSI in conjunction with each other. (For more, see Ride The RSI Rollercoaster and Exploring Oscillators and Indicators: RSI.)

Formula
Stochastics is measured with the %K line and the %D line, and 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:

%K = 100[(C – L5close)/(H5 – L5)]

C = the most recent closing price
L5 = the low of the five previous trading sessions
H5 = the highest price traded during the same 5 day period.

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

%D = 100 X (H3/L3)

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. For the purpose of realizing when a stock has moved into an overbought or oversold position, stochastics is the favored technical indicator as it is easy to perceive and has a high degree of accuracy.

Reading the Chart
The K line is the fastest and the D line is the slower of the two lines. 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 have written articles exploring the "tweaking" of this indicator, but new investors should concentrate on the basics of stochastics.

eBay.gif
Source: TradeStation

In the above chart of eBay, 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 $30.00 area to the mid $50.00 area. The current run in the stock started with a strong buy signal just two weeks ago. Although the buy signal appears to have been a false start, it has confirmed that, even in these tough market conditions for the Internet stocks, more new money is coming into eBay.

Conclusion
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.

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