Do you know what you want to buy, but are uncertain as to when to pull the trigger? When combined with other fundamental and technical tools, stochastics—a short-term technical indicator that is widely used among chart analysts for market signals—can help. Despite its geeky name, you don’t need to be a math whiz to use it. Actually, it’s quite simple, and can be particularly useful with a stock or a market that’s been moving sideways.
While the S&P 500 has been trending mostly higher since the June 2016 near-term bottom (see S&P 500 chart below), the pace of the rally has slowed over the past month. Based on the current value of the S&P 500, this indicator is suggesting that stocks are searching for direction over the short term.
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. It can be found beneath the price chart (see the chart below).
Stochastics is actually made up of two lines, which tend to move in tandem. %K (blue line) 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) attempts to smooth out the %K line by taking a three-day moving average of the %K line. Consequently, %D is generally considered the more important of the two. 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).
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. Note that 80 and 20 are the most common levels used, but can be adjusted per individual preferences.
What stochastics says about stocks now
Looking at a chart of the S&P 500 (see chart above), stochastics registered a buy signal in late March when both the %D and %K lines dipped just below the 20 reading, and then climbed higher. Both lines have been on the rise over the past few weeks and, as of mid April, are currently in the mid 50s.
This reading suggests there is not conviction to the upside or downside for the broad market. If you like using this indicator, keep an eye on whether it continues to rise, thus potentially generating a sell signal if it rises above 80 and then falls below that level, or potentially generating a buy signal if it falls below 20 and then rises above that level.
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, as well as a macro-economic analysis of the market and business cycle, and, if used with individual stocks, an analysis of earnings and other company fundamentals.
A few tips
It’s important to note 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 necessarily meaning the stock is becoming more oversold. For example, in February 2016, both stochastic lines for the S&P 500 held above 80 for several weeks; this should not have been interpreted as the market becoming more overpriced.
One 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 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.
- Read more about stochastics.
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