What it is:
The stochastic oscillator is a momentum indicator that shows the location of the current closing price of a security (or index) relative to the high/low range over a set number of periods.
The idea behind stochastics is that as the price of a security increases, the closing price will fall closer to the highest point over a given period. As the price decreases, the close will fall closer to the lowest low. Stochastics is therefore used to determine the best entry and exit points for a trade.
How it works (Example):
Stochastics has two components: %K and %D.
First, a value known as %K is calculated with this formula:
C is the most recent closing price; L14 is the lowest price in the last fourteen periods; and H14 is the highest price in the last fourteen periods. We used 14 as an example, but any number can be used here.
A 3-period moving average of %K is then calculated and called %D.
Stochastics is plotted with a positive scale that ranges from 0 to +100. A reading over 80 shows the stock/index is highly overbought; if the indicator is below 20, the security/index is oversold. 50 is an important mid-point: A cross above 50 shows prices are trading in the upper half of their range; a cross below 50 shows the opposite.
A significant buy or sell signal is given only when both %K and %D are both above or below overbought or oversold levels.
The calculation of full stochastics (note there are a number of different types of stochastics measurements) is based on a smoothed moving average to reduce the choppiness and volatility of the indicator, which can move quickly as the price surges or drops.
Why it Matters:
Observing stochastics in relation to overbought or oversold levels can help determine when best to enter or exit a trade.
Momentum indicators are designed to smooth the price moves and allow technicians to observe the underlying trend of the market. By focusing solely on the trend, the analyst should be able to make better decisions, since the noise associated with minor movements is filtered out. Momentum indicators, like stochastics, try to identify turning points by measuring how quickly prices are rising or falling.
One problem with using indicators to generate trading signals is that there are a large number of losing trades. One way to improve the odds of a winning trade is to ignore signals unless the market is at an oversold or overbought extreme. For stochastics, readings below 20 are considered oversold, and you would only take buy signals if the indicator is below that level. A value of 80 is considered overbought and sell signals occurring below that level would be ignored. This leads to longer trades and should result in fewer losses.
In the end, that is the primary objective of technical analysis – to find trading opportunities that minimize the risk of loss. The past is only a guide to the future, and all technical tools offer only a probability of what will unfold. Managing risk is the key to making money with technical analysis. In 2008, a bear market took nearly 50 percent off the value of many stock indexes. Technical tools, such as the stochastic indicator, could have helped investors to avoid many of those losses.