Stochastics is used in technical analysis as an indicator that helps to determine when a market is overbought or oversold. This method of technical analysis was developed by a technical analyst named George Lane. This indicator is used to evaluate a market’s momentum by determining the relative position of its closing prices within the high-low range of a specified number of days. The principle behind this technical analysis indicator is that a stock’s closing price tends to trade at the high end of the day’s price action. The price action is the prices at which a stock is traded throughout a daily session. In other words, the assumption is that when a stock is rising it tends to close near the high and conversely when a stock is falling it tends to close near its lows. This indicator is a momentum oscillator that can warn of strength or weakness in the market.

Without getting into the calculation too much, stochastics is measured with the %K line (fast line) and the %D line (slow line). The %D line is the line followed very closely and it indicates major signals in a chart. This is similar to plotting moving averages as well. The %K line is more sensitive than the %D line, and the %K line is a fast moving average. The %D line is a slow moving average of %K. The %D line, as stated above, is what triggers the trading signals. These trigger lines are typically drawn on stock charts at the 80% and 20% levels, whereas the %K and %D lines are plotted on a 1 to 100 scale. When these lines are crossed on a chart the signal is generated.

What does this technical indicator signify is occurring in the markets?
The purpose of this indicator is to alert traders that the bulls have failed to close prices near the highs of an uptrend. In can also indicate the failure of the bears to close prices near the lows of a downtrend. This is because prices will typically close near the top of the recent range in a strong uptrend. Then when an uptrend is approaching a turning point, the prices begin to close further away from the high of the range.  In a strong downtrend, the prices tend to close near the bottom of the range. As the downtrend is weakening the prices will typically close farther away from the low of the range.

Additionally, it is important to note that the 80% value mentioned above is an overbought warning signal whereas the 20% value is an oversold warning signal. These signals are the most reliable when traders wait until the %K and %D lines turn upward below 5% before buying, and also when the lines turn downward above 95% before selling.

Stochastics is a technical analysis indicator that is quite complex, but once understood can be a very valuable trading tool.

Please also read about Japanese Candlesticks which is another trading strategy used by some of the world’s most successful traders. It is the fastest way for new investors to quickly and accurately read stock charts. Once you are comfortable with the major candlestick signals, expand your expertise by learning the secondary Candlestick Patterns. Combine these with your favorite technical analysis indicators, such as the moving average convergence divergence indicator, and you have the perfect trading arsenal for evaluating stocks, currencies, commodities, or exchange traded funds.

Please continue your technical analysis education and read about fibonacci numbers.