Many investors look to various tools to help them gain an edge on the future direction of a stock. One such tool is stochastics which in theory is designed to give you a leading indicator of which way a stock is going. It is a computation that uses moving averages, i.e., historical data, to project future price movements in the short term.
We have used the stochastics indicator in the past, and we still use it today. We have found, however, that its use is best limited to those stocks that are moving sideways either in a flat consolidation or are rolling up and down in a trading range. That way the stochastic indicator sets up a more regular pattern that can be interpreted without the many false signals the indicator can generate. If you try to use it on a stock that is trending up or down, you can be misled by false signals.
The stochastics indicator consists of two lines and three ranges. The lines are known as the fast indicator (%k) and the slow indicator (%D). The three ranges are divided into below 20%, above 80%, and the range in between the two.
In its simplest form, stochastics can be interpreted by watching where the moving lines cross. The key areas to watch where a crossover occurs are above the 80% line and below the 20% line. These moves give the most reliable indications. If the fast indicator line crosses over the slow indicator line above the 80% range, that can be a bearish indicator. Note, however, that once a stochastics indicator crosses the 80% line it can move sideways indefinitely with the fast indicator tapping on top of the slow indicator line or even crossing the line back and forth. This happens when a stock is now longer in a trading range but has broken out and is trending further up.
If the fast indicator line crosses over the slow indicator line below the 20% line, it is a bullish signal. Again, however, if a stock breaks below its range and continues to trend down, the line can cross over and then continue to move down, causing the stochastics lines to continue to move sideways below the 20% line.
As with many indicators, looking for divergences can be the most advantageous use of the stochastics indicator as the peaks and valleys analysis described above can lead to false buy and sell signals. When looking for divergences that can give a clue to future stock movement, watch the relationship between the slow indicator line and the price movement. An overbought condition exists when the slow indicator line makes a series of lower lows while the price makes a series of higher highs. The price could be in for a serious down cycle. An oversold condition exists when the price makes a series of lower lows while the slow indicator is making higher lows.