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Stochastics and stocks

The US debt ceiling. Home retailer hiccups. Regional bank failures. Rate hikes. There's been no shortage of potentially market-moving events lately. Yet through it all, stocks have been moving sideways over the past couple months, as company earnings have largely come in better than expected and investors are anticipating the Federal Reserve may be at or nearing the end of raising rates during this cycle.

So, where might stocks go from here? Earnings will continue to drive stock prices, and if you use charts to plot your next move, stochastics suggest sideways-moving strategies could continue to dominate over the short term. Here's why. 

What are 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. 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®

Stochastics applied to the S&P 500® chart
Source: Active Trader Pro, as of May 17, 2023. The data, charts, and information shown above are provided solely for individual use and are not for distribution. Data and information shown are based on information known to Fidelity as of the date they were exported and are subject to change. Criteria and inputs entered, including the choice to make security comparisons or to show technical event opportunities (if available), are at the discretion of the user.

Stochastics are actually made up of 2 lines, which tend to move in tandem. %K (blue 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 (orange 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 are above 80 and move below that number, it indicates a sell signal. When stochastics are below 20 and move 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 are stochastics saying about stocks now?

It may be a particularly useful time to look at stochastics —if you like chart indicators. Momentum indicators like stochastics are considered more valuable by chart experts in sideways markets, compared with uptrends or downtrends, because of the way they oscillate between relatively overbought and oversold prices.

Looking at the chart above of the S&P 500 with slow stochastics applied, both the %D and %K line have been trending near the 50 level for several weeks. A reading like this does not indicate a buy or a sell signal. This indicator can be monitored until stochastics rise above 80 or drop below 20. The last instance of a clear signal given by stochastics occurred in early May, when a sell signal was generated and stocks declined thereafter.

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, for example, forms when price makes a lower low but stochastics form 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 trended sideways in recent weeks. It may be worth monitoring over the short term to see if there is a divergence.

Stochastics in context

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 or weeks) after it is generated.

Also, 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.

Of course, you shouldn't take a trading action based solely on this one signal. Like any technical indicator, stochastics are 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.

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Technical analysis focuses on market action — specifically, volume and price. Technical analysis is only one approach to analyzing stocks. When considering which stocks to buy or sell, you should use the approach that you're most comfortable with. As with all your investments, you must make your own determination as to whether an investment in any particular security or securities is right for you based on your investment objectives, risk tolerance, and financial situation. Past performance is no guarantee of future results.

The S&P 500® Index is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent US equity performance.

Indexes are unmanaged. It is not possible to invest directly in an index.

Past performance is no guarantee of future results.

Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.

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