Stocks and stochastics

Here's what this technical trading signal says about US stocks now.

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Weaker jobs data, higher inflation data, and some weakness for tech stocks have contributed to the recent pause for US stocks' upward momentum. The S&P 500 had hit a new all-time high in early May near 4,238. As of mid-May, stocks appear little changed since mid-April, and chart patterns that are best used in sideways markets may be particularly relevant for active investors that use technical analysis to invest some portion of their investment money in this type of market action.

When combined with other fundamental and technical methods, stochastics—a short-term indicator that is used by chart analysts for market signals—can help you interpret potential patterns. Based on recent action of the S&P 500, this indicator suggests short-term investors should keep watching the charts.

What is stochastics?

Similar to the Relative Strength Index (RSI) and Moving Average Convergence/Divergence (MACD), stochastics are a momentum measure that ranges from 0 to 100. The reason why momentum indicators like stochastics are considered more useful in sideways markets, compared with uptrends or downtrends, is due to the nature of the way they oscillate between relatively overbought and oversold prices. If you add this indicator to your charts, stochastics can typically be found beneath the price chart (see Stochastics applied to the S&P 500 below).

Stochastics is actually made up of 2 lines, which tend to move in tandem. %K (gray line in the bottom half of the chart above) represents the level of the stock or index's closing price relative to the high and low range over a specified period of time, and %D (red line in the bottom half of the chart above) attempts to smooth out the %K line by taking a 3-day moving average of the %K line. Consequently, %D is generally considered the more important of the 2 lines.

The theory behind stochastics is that these lines generate buy or sell signals when closing prices are near recent extreme highs or lows (i.e., sell signals after an uptrend and buy signals after a downtrend). Note that the time frame you pick when using stochastics, or other indicators/fundamentals, is at your discretion, and there is no consensus view as to what time frame optimizes stochastics. 

Generally, the area above 80 indicates an overbought region, while the area below 20 is considered an oversold region. When stochastics is above 80 and moves below that number, it indicates a sell signal. When stochastics is below 20 and moves above that number, it indicates a buy signal. 80 and 20 are the most common signal levels used, but can be adjusted per individual preferences.

What stochastics says about stocks now

Looking at the chart above of the S&P 500 with slow stochastics applied, recent signals given by this indicator were a sell signal in late-April when both lines crossed above and subsequently below 80, and a buy signal in late-October when both lines dropped below and subsequently crossed above 20. During the most recent bottom for stochastics, neither the %D nor %K line dropped below 20 to generate a buy signal (the %K line came close, falling to 20.94, while the %D line fell only to 26.75). Chart users who like using stochastics would want to monitor this indicator to see if stochastics fall below the 20 line and subsequently rise above it to generate a buy signal. It's worth noting that, once a trading signal is generated by a technical indicator such as stochastics, that doesn't necessarily mean that signal (to buy or sell) stays in effect until a contrary signal is generated. Rather, they can be thought of as a trading indicator that is relevant for a short period of time (e.g., a few days) after it is generated.

Another pattern that can be observed when using stochastics is a divergence between the direction of the stochastics indicator and a stock or index, such as the S&P 500. Divergences form when a new high or low in price is not confirmed by a new high or low in stochastics. A bullish divergence forms when price makes a lower low but stochastics forms a higher low. This could indicate less downward momentum and could foreshadow a bullish reversal. This has not occurred recently, as both the S&P 500 and stochastics have made lower lows over the past several trading sessions, but it may be worth monitoring over the short term to see if there is a divergence.

Of course, you shouldn't take a trading action based solely on this one signal. Like any technical indicator, stochastics is best used in combination with other technical indicators, such as volume trends, as well as a macroeconomic analysis of the market and business cycle, and, if used with individual stocks, an analysis of earnings and more company fundamentals.

More importantly, ongoing developments with the COVID-19 pandemic—including rates in new infections, deaths, and vaccinations—and the impact on economic activity, should continue to dominate chart trends.

Additional tips

It's important to understand that momentum indicators—including stochastics—can remain above 80 in overbought levels for extended periods after an upturn, without indicating that the security is becoming more overpriced (this was the case for all of April). Similarly, stochastics can remain below 20 in oversold territory for extended periods after a sustained downtrend, without meaning the stock is becoming more oversold. Finally, remember to temper your reliance on technical indicators during these unprecedented times due to the heightened risk of extreme volatility associated with COVID-19.

Next steps to consider

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