The stochastics indicator is a relatively known momentum indicator which shows the most recent closing price to the highs and lows of the period. By comparing closing price with the previous trading range- it defines overbought and oversold levels along with potential signals that could suggest entry or exit points.
Who invented it?
The stochastics indicator was invented in the 1950s by George Lane, a securities trader, author, educator, speaker and technical analyst. It was conceived in the Dystant Investment Education School in Chicago and was the result of a long research project. C. Ralph Dystant (1902-1978) and George C. Lane (1921-2004), along with three other analysts, developed this new oscillator. They initially computed all the calculations by hand while “in the sixties, we pioneered using the computer to test our oscillators.” (George Lane) It was only in the late 80’s and 90’s that this technical indicator gained popularity, imposing itself as one of the most popular and widely used technical indicator.
How does it Work?
The Stochastics indicator is an oscillator that varies from 0 to 100. It is formed by two moving lines: %K and %D.
The Mathematics Behind
The goal of this indicator is to understand and predict trend changes. The %K value is the percentage originated by the comparison of the current closing price and the trading range of the selected period.
The formulae are:
The lines are represented in a chart with two horizontal lines that act as thresholds. These represent the oversold and overbought conditions. The levels are usually around 30% – 20% for the Oversold and 70% - 80% for the Overbought (see graph above) . When the %D and %K lines are above the upper horizontal line (OB), it means that the price is “too-high” now and a downturn is likely to occur. Same applies for our oscillator’s lines crossing below the OS: an upturn is expected.
If we look at the previous graph, we can recognize some of the signals:
The Stochastics is therefore a momentum indicator. The oscillator, hence, provides the user with Oversold and Overbought conditions. Another signal that this indicator generates, occurs when the %K and its moving average %D cross. This happens due to price action and highlights possible trend reversion points.
What does it tell us?
Using this indicator can be useful to predict trend changes and try to understand when the security’s momentum is “running out of steam”. Similar to the RSI (Relative Strength Index) it measures momentum focusing, however, on the closing price, rather than on the velocity of price changes. For this reason, the stochastics is believed to work well in sideways or choppy markets. Comparing momentum indicators with the real price action will allow also to take advantage of divergence, further reinforcing trend reversals. Despite this, as any technical indicator, it can produce false signals and lead to wrong conclusions.
We will now see two examples of securities (S&P 500 and EUR/USD) in order to compare the price chart with the oscillator.
In Green: Correct signals In Red: False signals
As we can see, the lines above and below the pink area (20-80%) are the overbought and oversold levels. Crosses of the %D and %K lines help understanding entry points (see the cross before April in the SP-500 chart).
Summing it up, it is clear that the Stochastic technical indicator provides the user with some interesting information and data about the current price action. Together with others it might be very useful for the validation or analysis of a certain security.