Trading with stochastics

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The latest round of tariffs implemented by both the US and China appears to have interrupted the strong year-to-date uptrend for global stocks—the MSCI World Index is up 11% in 2019 thus far. Amid this new trade tremor, earnings remain strong and liquidity has been improving.

Active investors may be wondering if the recent pullback is a short-term buying opportunity or if there is more downside to come. If you know what you want to buy or sell, but are uncertain as to when to pull the trigger, you might consider stochastics—a short-term technical indicator that is widely used among chart analysts for market signals. When combined with other fundamental and technical tools, stochastics can help you time your trading decisions, and it can be particularly useful with a stock or a market that is moving sideways.

Based on recent action of the S&P 500, this indicator is suggesting that US stocks may be close to registering a buy signal, but there are other reasons to be cautious.

What is stochastics?

Similar to the Relative Strength Index (RSI) and Moving Average Convergence/Divergence (MACD), stochastics is 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 applied to the S&P 500^®

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Stochastics is actually made up of 2 lines, which tend to move in tandem. %K (blue line in the chart above) represents the level of the stock or index's closing price relative to the high and low range over a period of time, and %D (red line in 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 under analysis using stochastics, or other indicators/fundamentals, is at your discretion.

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 of the S&P 500 above, both stochastics lines have been trending lower since the end of April, when the indicator generated a sell signal. If these lines continue to fall below the 20 reading (the %K line has declined below the 30 line, as of mid-May), and then subsequently rebound above that level, that would generate a buy signal.

Of course, it's possible that the indicator remains above the oversold line for an extended period of time (and does not generate a signal). Also, given the mostly upward direction of stocks in recent months, the stochastics indicator would become more valuable if the market trades sideways for a longer period of time.

Moreover, 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 data can help you determine if the trading signals generated by stochastics are valid, according to your analysis. Of note, stochastics gave 2 sell signals in March that did not lead to a subsequent short-term decline.

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. Similarly, stochastics can remain below 20 in oversold territory for extended periods after a sustained downtrend, without meaning the stock is becoming more oversold. For example, both stochastics lines for the S&P 500 held above 80 for most of January and February; this should not have been interpreted as the market becoming more overpriced.

Another thing to watch for is divergences between the direction of the stochastics indicator and the price of the stock/security. 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 (see an example in the chart below). This could indicate less downward momentum and could foreshadow a bullish reversal.

Alternatively, a bearish divergence forms when price makes a higher high but stochastics forms a lower high. This could show less upward momentum and could foreshadow a bearish reversal. Recently, there appear not to have been any significant divergences between stochastics and the price of the S&P 500, but it may be worth monitoring to see if this does occur.

Finally, some technical analysts look at whether indicators are making higher highs/lower lows to confirm the direction of a trend, or lower highs/higher lows to confirm a change in trend direction. The S&P 500 chart shows how stochastics has made 2 higher lows over the past month, a potential signal that the market may return to its bullish trend.