Stochastics in Stock Market Analysis
The stochastic oscillator is a chart indicator used by stock technical analysts to help them determine the future direction of stocks and other securities. Set at the bottom of a price chart, the stochastic is plotted on a graph that ranges between zero and 100. Primarily, the stochastic measures price momentum, but it has a wide range of uses for analysts who know how to interpret it correctly.
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Overbought and Oversold
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The most common use of the stochastic indicator is to measure whether a stock price is overbought or oversold relative to its recent price range. In other words, if the price moves too far above its recent mean, theoretically the stock is considered overbought and it should correct lower. Likewise, if the price moves too far below its recent mean, it should correct higher. Generally, a stock is considered oversold if the stochastic line on the graph is below 20, and overbought if it is above 80.
Adjusting Parameters
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The default settings for most stochastic indicators is %K(14) and %D(3). This sets a 14-period price average against a three-period average, which are then calculated by a formula to create the indicator line on the plotted area of the chart. Most chart programs allow analysts to set their own parameters for the stochastic indicator. If you adjust %D to five, for example, the stochastic will slow down. A slower stochastic provides less overbought and oversold signals, but they may be more reliable. The best thing to do is experiment with the numbers and find a combination that works best for you.
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Divergences
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Generally speaking, momentum tends to drop off before the price reverses. The stochastic indicator measures momentum, so it can offer a reliable trading signal when it diverges against the price. For example, when the price of a stock is rising while the stochastic is simultaneously falling, it indicates that the stock's momentum is waning. This, in turn, indicates that the stock price may be ready to reverse in the near future.
Confirmation
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The stochastic is also a good tool to use for confirmation. If the price of a stock is rising and the stochastic is also rising, it shows that the price move has good momentum behind it. Likewise, a bullish divergence sometimes also emerges, which confirms the price rise has momentum behind it. If the price of a stock is rising and the stochastic reading rises more quickly than previous similar price rises, a bullish divergence is formed, indicating price momentum is strong.
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References
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