Stochastics Made Simple

 Stochastic indicators were first developed by George Lane, a physician with a keen interest in technical analysis. Like many popular technical tools stochastic indicators are best learned through detailed and patient observation. You can read a book about them and feel you understand the subject pretty well, but nothing will multiply the value of what you've learned as quickly as watching how the indicators play out on a real-time chart and through live trading.

Stochastic indicators are a very popular tool used by traders to determine when trend reversals are most likely to occur. Because the indicator is gauging when trends "grow tired", the application of the tool is inversely related. The theory is that in an upwardly trending market price bars tend to close near their highs and in a downwardly trending market near their lows. Furthermore, as an upward trend matures, prices tend to close further from their highs; and as a downward trend matures, they close further from their lows. Thus if a stock is overbought, price bars will start to cluster around their lows in an up trending
market; and when a stock is oversold, prices will tend to cluster around their highs in a down trending market. These are among the earliest signs that the trend is about to change.

The stochastic is plotted on a chart with values ranging from 0 to 100. Reading above 80 indicate that closing prices are clustering near highs and readings below 20 indicate that closing prices are clustering around lows.

The indicator is plotted as two lines: the %D line and the %K line. Most often the %K line will change before %D line. Ideally what we look for is a crossover of both lines down through the 80% line and up through the 20% line. When the indicator approaches either 0 or 100, the trend is usually suspect.

Our use of stochastics indicators emphasise diverging lines above all. In such instances, price may be making higher highs while the stochastic oscillator is making lower lows; or price may be making lower highs while the stochastic oscillator is making higher highs. In either case, the indicator usually is signalling a change in the trend before it is obvious in the price bars.

One more note concerning stochastic indicators, if the picture is unclear in one time frame, you can step down or step up the time frame for corroboration.

Christopher M. Quigley B.Sc., M.A., QFA