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Stochastics Made Simple

By Rick Ackerman

Like many popular technical tools, stochastic indicators are best learned through detailed and patient observation. You can read a book about them and feel like you understand the subject pretty well, but nothing will multiply the value of what you’ve learned as quickly as watching how the indicators play out on a real-time chart and through live trading. And so it is with stochastic indicators, about which numerous excellent books have been published. However, if you’d rather accelerate the learning process and get down to action, below are some pointers that should help speed your way.

First, some definitions. Stochastic indicators are a very popular tool used by traders to determine when trend reversals are most likely to occur. Because the indicator is gauging when trends grow “tired,” the application of the tool is inversely related, as will be explained in detail. The theory is that, in an upwardly trending market, price bars tend to close near their highs, and in a downwardly trending market, near their lows. Furthermore, as an upward trend matures, prices tend to close further from their highs; and as a downward trend matures, further from their lows.

The word “mature” in this context is understood by chartists and technicians to mean either “overbought” or “oversold” -- the two conditions which stochastic analysis seeks to identify. Thus, if a stock is overbought, price bars will start to cluster around their lows in an uptrending market; and when a stock is oversold, prices will tend to cluster around their highs in a downtrending market. These are among the earliest signs that the trend is about to change.

Stochastic indicators were developed by George Lane, a physician with a keen interest in technical analysis. Their mathematical derivation is given immediately below, but as implied earlier, the arithmetic is ultimately of less importance than the process of training one’s eye to recognize telling stochastic patterns on a chart. We’ll look at some charts in a moment, but first a refresher on the stochastics formula, which is important to one’s understanding of what stochastic indicators actually measure. You won’t need to replicate the following calculations yourself, but it will nonetheless be helpful for you to understand the derivation of several variables that are used in stochastic models. These variables are often required as simple plug-ins for charting software applications commonly used by traders.

Some Definitions and Calculations

The stochastic indicator is plotted as two lines: the %D line and the %K line. You will notice the formula is similar in its components to Welles Wilder’s Directional Indicator, which we wrote about here last month. The %K line is the less important of the two and is represented by the following equation:

%K = 100[(C - L5close)/(H5 - L5)] where:

C = the most recent close
L5 = the lowest low for the last 5 trading periods
H5 = highest high for the same five trading periods

%D is a smoothed version of the %K line, usually using 3 trading periods. The %D equation is as follows:

%D = 100 X (H3/L3) where:

H3 = the 3 period sum of (C - L5)
L3 = the 3 period sum of (H5 - L5

The stochastic is plotted on a chart with values ranging from 0 to 100. The value cannot fall below 0 or rise above 100. Readings above 80 indicate that closing prices are clustering near highs, and readings below 20 indicate that closing prices are clustering near lows. Following is a chart to illustrate, with stochastic indicators plotted beneath price changes in the S&P 500 futures:

Reading the Indicator

Most often, the %K line will change direction before the %D line. However, when the reverse is true, we should look for a trend reversal. When both %K and %D lines change direction, then the %K retests the support of the %D line without breaking it, this implies that the price reversal is likely to have begun a new trend.

When the indicator approaches either 0 or 100, the trend is suspect. Following a price retracement, if the indicator retests these extremes, it is often signaling an opportune entry point. Quite often, when the %K or %D lines begin to flatten, a trend reversal will occur, begun at the next trading range.

Our use of stochastic indicators emphasizes diverging lines above all. In such instances, price may be making higher highs while the stochastic oscillator is making lower lows; or, price may be making lower highs while the stochastic oscillator is making higher highs. In either case, the indicator usually is signaling a change in the trend before it is visually obvious in the price bars.

The ability to interpret such divergences can be very helpful in identifying major turning points in real time. To do so, you must first be able to recognize four different types of divergences -- two found at market tops, two at bottoms. Charts illustrating these divergences appear below.

Type I Top (Higher price peaks with correspondingly lower stochastic peaks):

In the chart above, price action in a stock is plotted with a stochastic line beneath. You will note that, although the stock has made successively higher price peaks, the stochastic peaks have declined. A useful way to interpret this is to say that, as the stock went higher, the eagerness of buyers diminished. Or, you could say that the second rally, while producing a higher price peak, failed to get as overbought as the first. This is an intuitively bearish proposition, and there’s no reason to complicate this line of reasoning with further details. You now understand why stochastic divergence associated with rally tops constitute a flashing yellow signal for bulls.

Type II Top (Lower price peaks with correspondingly higher stochastic peaks):

Above is a chart illustrating the other type of divergence possible at a rally top; it also is interpreted as bearish. Here, price peaks have declined while the stochastic peaks that correspond to them have risen. Think of it as implying that the stock got even more overbought while failing to make new highs. You could also see it as a “distributive” pattern, where buyers expended a good deal of enthusiasm -- rendered the stock “overbought,” that is -- without being able to push it to new price highs.

Type I Bottom (Lower price bottoms with correspondingly higher stochastic bottoms):

Now we’re thinking upside down: Stochastic divergences at the bottom of a chart are typically a bullish indicator. In the illustration above, we see that lower price bottoms have generated correspondingly higher stochastic bottoms. We should infer that, even though the stock was moving lower, sellers were less brutal in pounding it down. Sound bullish? That’s all you need to know about the signal (although other confirming indicators should be used to determine “market alignment,” a concept that will be covered in a future article).

Type II Bottom (Higher price bottoms with correspondingly lower stochastic bottoms):

Here’s the other type of bullish bottom, where higher price lows have generated lower stochastic lows. Based on personal experience, this is a somewhat more bullish pattern than the Type 1 Bottom. (This observation applies to the examples of diverging tops, as well: Type 2’s are generally more bearish than Type 1’s.) We should view Type 2 bottoms as implying that sellers have spent their fury: oversold as the stock became, the selling could not push it to a new low. That’s about all you need to know, but we’ll throw in a somewhat rarer pattern that can signal a humdinger of a rally or decline: Double Divergence.

Double Divergence

There is another divergent pattern which can indicate a powerful trend change at tops and bottoms. We call it a “double divergence,” and it requires three discrete peaks or bottoms to manifest itself. A double-diverging top would looks like this:

Note that there are three price peaks, labeled A, B & C, and that they have generated respective stochastic peaks at a’, b’ & c’. What is distinctive about this chart is that all of the respective peaks diverge from each other -- that is, A and B diverge relative to a’ and b’ ; A & C diverge relative to a’ and c’ ; and B & C diverge relative to b’ and c’ . This pattern is relatively rare, but when you see it taking shape on a chart, you should fasten your seatbelt in preparation for a wicked turn. The same pattern can occur at bottoms as well, producing an inversion of the chart reproduced above.

To Summarize...

Interpreting these patterns is straightforward and not at all difficult. To review what we’ve learned: A divergence of either Type I or II at market tops is bearish, while a divergence of either type at bottoms is bullish. If there is no divergence, it is usually an indication that the trend will continue, possibly following a normal correction.

One more note concerning stochastic indicators: Everything you have learned about them can be applied in any time frame, whether a 5-minute bar chart or a monthly chart. Occasionally, double divergences will crop up in the one- or five-minute bars, signaling unusual trading opportunities. By extension, a double-divergent pattern in a monthly chart could signal the beginning of a major bull or bear market.

If the picture is unclear in one time frame, you can step down to a smaller time frame to see whether one corroborates the other. For instance, stochastic indicators for a daily-bar chart might be very bearish while indicators for the monthly chart are very bullish, just starting to roll up from extremely oversold lows. If this is the case, you might initiate a long position when the daily-chart indicators approach oversold extremes, and signal a trend change by way of a re-test such as described above. Immediately below is a monthly chart of General Electric (GE). The powerful Type 1 divergence was a strong clue as to how important the September 21 low was going to be. We should also observe that there is potential in the stock’s chart to create a Type 2 top, which would be very bearish. All it would take would be for the stock to roll down from 66, since the stochastic top already in exceeds the top corresponding with the 2001 high near 68.

Finally, you should be aware that these signals are not often so obvious as to shout “Buy here!” or “Sell there!” In fact, they tend to be both subtle and subjective, and that is why one must study and observe them diligently over time to become proficient in their use. In fact, to trade literally on any one indicator would not be prudent. All traders must use confirming indicators as well to either confirm the stochastic signal or refute it. This “market alignment” of indicators will be the focus of a future article. In the interim, we hope you apply this approach to your trading, since we have found it to be among the strongest trend-reversal indicators available.