Stocks and stochastics

If stocks are closer to trading "normally," you can use indicators to value the market again.

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Despite the 2-month rally that has erased more than half of the COVID-19 stock market losses, it would be foolish to assume that coronavirus volatility is gone for good. Unemployment claims are at all-time highs, consumer sentiment is near multiyear lows, and new cases of COVID-19 and related mortalities have not receded to where health officials believe economic activity can return entirely to normal.

However, the historic price swings that occurred in late February and most of March have abated significantly (see US stocks settle after early COVID-19 reaction chart).

That's important for investors that use charts and technical tools to trade the market. Technical analysis looks for repeatable patterns. Volatility from COVID-19 sent stocks spiraling in unpredictable directions, making most technical tools less reliable. Many technical indicators are more useful with a stock or a market that is stable or moving sideways. That's why this smoother market action may mean pattern analysis may be more reliable than in previous weeks and months.

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 is suggesting some short-term caution for US stocks.

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 is actually made up of 2 lines, which tend to move in tandem. %K (light 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 specified period of time, and %D (gray 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 you pick when 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 above of the S&P 500, recent signals given by stochastics were a buy signal in March (just ahead of the near-term COVID-19 market bottom) when both lines dropped below and subsequently crossed above 20, and a sell signal in late April when both lines crossed above and subsequently dropped below 80. This past week, both stochastics lines have reapproached oversold territory.

Another pattern that has emerged is a divergence between the direction of the stochastics indicator and 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. In the chart you can see that stochastics have made lower lows and lower highs (a bearish signal).

This suggests, based on this indicator alone, that the short-term outlook may be bearish. Indeed, as the economy begins to open back up, there is significant uncertainty as to the pace of a recovery as well as COVID-19 infection rates.

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.

Moreover, it is critically important to remember that developments with the COVID-19 pandemic can render the signals generated by indicators such as stochastics irrelevant. For example, stochastics for the S&P 500 registered a sell signal right before the market tumbled when the pandemic took hold in the US, but then gave a buy signal less than 2 weeks later—yet US stocks would continue to plunge for nearly 3 more weeks. Even though trading activity has settled relative to those tumultuous weeks, exercise caution using indicators in this market.

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. 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

Find new investing ideas and get up-to-the-minute market data.

Learn what you need to know before trading the market.

Learn about more technical indicators and how they can help you trade.

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