How to use the stochastic indicator in the stock market?

The stochastic indicator in technical analysis: What is it?

First of all, let us recall that the term "stochastic" comes from mathematics and more precisely from probability. It corresponds to the evolution of a random variable. Thus, in terms of technical analysis in the stock market, the stochastic corresponds to a technical indicator that was created by George Lane, a famous American trader and analyst, in the 1950s.

The stochastic indicator belongs to the oscillator family of indicators. This means that it oscillates between two values and more precisely here between 0 and 100.

As far as its use is concerned, the main objective of the stochastic indicator in the stock market is to define the moment when the price momentum of an asset turns around. To do this, it will use the current closing price and previous closing prices over a defined period.

How is the stochastic calculated in the stock market?

To calculate the stochastic indicator, we use the two lines defined as follows:

• %K = 100 * ((Current closing price - Bn)/(Hn - Bn))

○ With Bn for the lowest price and Hn for the highest price over N periods

• %D = the moving average of %K over N periods

As mentioned before, the stochastic is between 0 and 100 and therefore its value cannot be negative. When the value of the stochastic is close to 100%, it means that the current closing price of the asset is close to the highest price of the defined period. Conversely, when the stochastic is close to 0%, it means that the current closing price is close to the lowest price of the period in question.

If the calculation of the stochastic indicator seems complex, don't worry! You don't have to do it yourself because most trading platforms allow you to display it on the chart or to consult it directly via an automatic calculation.

Most often and graphically, the stochastic indicator is displayed by several lines of several colours with :

• In blue: the %K line
• In red: the %D line
• In black :

○ the level of the 80% high horizontal line

○ The level of the 50% middle horizontal line

○ The level of the 20% low horizontal line.

It should also be noted that while the stochastic can never exceed the extreme values of 0 and 100, it is generally read between 20 and 80%. This is because when the %K line reaches the 80% zone, it means that the asset is overvalued and, conversely, if it reaches the 20% zone, it means that the asset is undervalued.

How is the stochastic indicator used in the stock market?

It is possible to use the stochastic indicator in different ways in the stock market by studying either crossovers, the %K level or divergences. All of these methods aim to detect a stochastic buy or sell signal.

With the crossing method, the crossing of the lines %K and %D with each other or the crossing of the line %K with the 50% will be studied.

For the study of the crossings between the lines %K and %D, note :

• A buy signal when the blue line crosses the red line from above
• A sell signal when the blue line crosses the red line from below

With regard to the study of the crossings of %K with the 50%, we note :

• A buy signal when the blue line crosses the middle horizontal line from above
• A sell signal when the blue line crosses the middle horizontal line from below

With the %K level assessment method, we will note :

• A sell signal is given when the blue line moves above 80% and crosses the high horizontal line on the downside.
• A buy signal is given when the blue line moves below 20% and crosses the low horizontal line.

Finally, if you use the stochastic divergence method, it will show you a bullish divergence or a bearish divergence.

• Bullish divergence will be expressed by the formation of two consecutive lows with a recent low lower than the previous low and, simultaneously, two lows with the most recent higher than its previous low.
• Bearish divergence will be expressed by the formation of two consecutive highs with the most recent high higher than the previous high and, simultaneously, two highs with the most recent high lower than the previous high.

How to set up and adjust the stochastic indicator on the charts?

As you may already know, the stochastic indicator is a very frequently used indicator in the stock market and is therefore proposed by default in most of the customizable charts of the market brokers. You can therefore use it very easily from the trading platform of your online broker, by simply displaying it on the charts of your assets.

The only parameter that you will have to take into account to obtain signals from the stochastic indicator concerns some settings. Remember that the stochastic indicator can be used to implement different trading strategies in the stock market. It is therefore not possible to define a basic parameter that will correspond to all investors. However, to help you set up your stochastic indicator on the stock market charts, you can base yourself on these elements according to your investment horizon:

• If you are considering a short-term strategy, your stochastic indicator could be set at 14.3.3
• If you are considering a longer-term strategy, you can keep the default values of this stochastic indicator

Of course, don't hesitate to test several methods and settings in order to get to grips with this indicator and don't neglect the other important indicators for technical analysis.

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