Stochastic is a momentum indicator and plays an important role in technical analysis for a trader.Their significance lies in predicting the entry and exit prices in a trade.It was developed by George Lane.
There are lots of Technical Indicators available in Technical Analysis which traders use to strengthen their trading plan.The disadvantage with some of them is that they give buy or sell signal when the price move in the security has already occurred.So the chance to earn big profit may already have gone before these indicators give you the signal to enter the stock.
Uniqueness of Stochastic lies in the fact that it is a Leading Indicator besides giving more accurate entry or exit points than other lagging indicators.It generates signal before the move occurs in the stock,thus enabling the traders to maximize their profits.
Stochastic give the most recent closing price of a security in relation to the average highs and lows made by the security in a particular time frame.It consists of two lines ; %K and %D.Crossing of %K line above or below the %D line generates the buy and sell signals.In most of the trading software , %D line represents 3 time periods while %K line is for 5 time periods.
Calculation:- Now a days there is no need to manually calculate the stochastic as all the modern day charting software can draw it directly on the security chart,thus making it quite easy to apply it.The formula to calculate stochastic is as below :-
%K= [Closing-Low/High-Low price in previous 5 time periods]*100
%D=[High/Low of previous 3 time periods]*100
Interpretation of Stochastic :- Stochastic for a security keep fluctuating between 0 – 100 on the technical chart.It represents if the security is Overbought or Oversold.Values above 80 represent Overbought and values below 20 represent Oversold security and therefore possible reversal in the ongoing trend.We have to look for %K line crossover the %D line.When %K line crosses below 80 level after crossing above it and also crosses %D line in the process,it is a signal to go Short for the traders.Similarly,when the %K line crosses above 20 level after crossing below this level and also crosses %D line,it is a signal to go Long(see yellow arrows in the figure and corresponding stock moves in the chart above that)
It needs to be remembered that Overbought security may not start retracing back immediately and has the probability of remaining in overbought territory for extended periods of time.Similarly true is for Oversold conditions.So,it becomes imperative to trade in the direction of longer term trend of the market.In bull markets,you can look for oversold security to go long.On the other side,look to go short in overbought situations in a longer bearish trend.
Applying Stochastic as a single indicator to decide for a trade can not be 100% accurate.It is better if we apply it along with other indicators like Relative Strength Index (RSI) etc.Stochastic can be more useful if applied along with support and resistance for that stock or security.
Types of Stochastic:- Stochastic are of two types-
Fast stochastic are more sensitive to price moves and hence probability of errors can be there in very short-term trading.Slow stochastic being slow are more useful as being less sensitive,the margin of error is considerably reduced.So slow stochastic are more popular among the traders when looking to apply stochastic in their trading plan.
Divergences-In more advanced analysis,traders can look for Positive and Negative Divergences which indicates the potential trend which is about to start.
Positive Divergence is when the stock price is making new low while the stochastic is making highs after crossing 20 level.It indicates the bullish trend is about to start in the stock and the traders need to be positioned on the Long side.
Negative Divergence is when the stock is making new highs while the stochastic is making lows after crossing the 80 level.So traders need to be cautioned or should decide to go Short as the stock may start falling.