Technical analysis lies at the heart of stock market activity, where the performance of securities is broken down and studied like a science. Even the most beginner market players resort to basic analysis of this nature.
Through the study of stock patterns, market psychology, momentum, support, and resistance, traders can predict the movement of stocks on their radar, and often quite reliably so.
The edge this gives a trader is quite clear, as it informs one of price movement before it actually plays out.
With all the complexity and jargon surrounding technical analysis in the stock market, one question that often arises is, exactly what is stochastic analysis, and how does it compare against the growing toolkit of technical methods?
In this article, we delve deep to answer the question, of what is stochastic method is and how one can put it to use in predicting market trends.
What Is Stochastic?
To start off, we take on the question, ‘what is stochastic?’ head-on, and lay the facts bare.
At its most basic understanding, stochastic is a term that is a reference to a momentum indicator that helps identify whether a particular stock has its price on an upward or a downward trend. Understandably, this insight is incredibly valuable to market participants.
The indicator is usually called the stochastic oscillator because of its focus on price ranges, and the tendency of the stock price, at a particular time, to oscillate between this range.
The fundamental assumption with stochastic oscillators is that a stock will close towards the higher end of a range in the event of an upward-sloping price trend, and on the lower end when the trend is moving toward the bottom.
The way the stochastic oscillator tool is set up is by means of a standardized range from 0 to 100, with high readings suggesting overbuying, which means a downfall may be imminent, and an overselling for low readings on the range of the stock.
History Of The Stochastic
Attempting to investigate the question of what is stochastic method without delving into its history would be a flawed approach. This is because this would decontextualize this brilliant market tool from the realities that bore it into existence and widespread practice.
The stochastic oscillation tool was the brainchild of the renowned technical trader, George Lane, during the early 1950s. He established this after years of observation which confirmed the slowing down of momentum as stock prices approached extreme highs and lows.
The tool, which is also called Lane’s stochastics, brought the idea of range-bound trading into the mainstream. Today, in present times, it is a highly popular technical tool that is widely used by retail traders, to confirm trends and even predict reversals.
Relative Strength Index (RSI)
No discussion surrounding the stochastic indicator in trading is ever complete without the mention of the relative strength index (RSI), which is another momentum indicator that is commonly used by traders across the globe.
Unlike the stochastic tool which looks solely at price movement within a range, the RSI draws a comparison of average gains and losses in a particular time range. Based on this it determines whether the stock is approaching overbought or oversold territory.
When attempting to compare stochastic vs. Relative Strength Index (RSI), it is important to point out that RSI was developed much later, and accounts for a lot more than the price chart. As such, it is far more sensitive and versatile in its assessment of momentum.
However, both the stochastic oscillator and the RSI are powerful tools that use historical price trends to predict future movement and potential reversals. Anyone looking to embark on a range trading approach would see great utility from each of these brilliant technical tools.
Formula
Moving on to establishing a more practical foundation, we now turn to take a look at the formula of the stochastic oscillator, which is used by millions of traders on a daily basis. This is expressed below as follows:
As can be seen in the formula above, the stochastic value is derived as mentioned, in a percentage form, and represented by the symbol, %k. The following elements are required in order to determine this value at any point in time:
- Current Close: This represents the closing price of a stock in the day for which its stochastic level is being calculated.
- Low (n): In this part, the lowest price of the specified range will be input. Normally, for such calculations, financial analysts recommend selecting a fourteen-day range for the most reliable results.
- High (n): This represents the highest price the security touched during the chosen range and thus forms the upper limit within which the oscillation takes place.
Reading The Chart
In most cases, stochastic levels are represented by linear charts that are demonstrated alongside normal price trends or candlestick charts. This is showcased in the graphical example presented below:
As is evident, the chart is primarily gauged by two horizontal lines reflecting the 20% and 80% levels. Each of these levels is considered a critical point and is a call to action for the traders focused on the stochastic approach.
Whenever a price ventures above the 80% benchmark there is a strong indication that the stock has been overbought, based on its momentum, and its fall is imminent. Likewise, falling below the 20% level suggests an overselling and thus an oncoming price consolidation.
What Are Stochastics?
Now that we have a clear idea of what is stochastic, and how it is used by traders across the globe, we can take a more in-depth look into the core idea behind it.
The stochastic tool is built for those who highly value momentum as an indicator, and are ready to act on the signals put out, on the basis of momentum. As such, these point out bullish or bearish signals on the basis of how the stock price is moving in a given range.
Those that are well-versed in the stochastic method are aware that the stock price rarely lingers above or below the 80% and 20% levels, respectively. Hence, these are quick calls to action, in which traders are to act immediately to take advantage of the signals portrayed.
How Can I Use Stochastics in Trading?
When one has firmly understood what is stochastic and is ready to apply it to their trading strategy, there a range of ways in which they may apply it. Some of these are described below:
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Identify Overbuying And Overselling
The primary way the stochastic tool is used by traders is in identifying precise levels at which a stock is overbought or oversold, which can in turn guide buying or selling decisions.
It is important to note that this approach would only be applicable to retail traders over short-term horizons and not to investors attempting to tap into the long-term potential.
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Locating Crossovers
For traders looking into stochastic and its use in technical analysis one useful way it can be used is in locating crossovers. This refers to instances where the stochastic figure rises above or falls below its own 3-day simple average.
Much like the golden crossing, this phenomenon is a bullish or bearish signal which indicates a momentum reversal.
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Finding Divergences
For the more technically well-versed and experienced traders, one-way stochastics are used is in finding divergences in stochastic levels and the price of the stock. These indicate windows of opportunity where the market is yet to react to overbuying or overselling.
What Is A Stochastic Stock Chart?
The stochastic stock chart is a fundamental part of the wider stochastic tool that makes its application possible. Having a pictorial representation of shifting stochastic levels for a particular stock alongside its price movement significantly aids decision-making.
Because stochastic levels are represented in percentage terms, the chart showcases two horizontal lines at the 20% and 80% levels. In normal cases, the stochastic line would remain within these ranges, and venturing out would indicate overbuying or overselling.
Stochastic charts can be handy in a wide range of scenarios, and even for traders with different time ranges, whether short-term or long-term. Using them in conjunction with other tools such as the relative strength index can enhance the insight they deliver.
How Do You Make Stochastic Charts With Excel?
Having elaborated on what is stochastic chart and how it assists traders, the next logical step would be to learn how to generate this with a simple spreadsheet application, such as Microsoft excel. The following steps will be needed to complete this:
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Data Collection
You will need to gather the historical prices of the stock you are looking to analyze. You can collect this data from various sources, such as dedicated websites or financial data providers.
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Calculate Stochastic Values
To do this, you would need to specify a range and then input the closing prices into the stochastic formula, which has been elaborated upon, above.
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Enter Values
Open a fresh Excel spreadsheet and enter the historical prices and the Stochastic values you calculated for each day.
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Create A Chart
Highlight the data and click on the “Insert” tab. Select the line chart as the chart type for the stochastic graph.
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Customize The Chart
You can customize the chart by adding titles, axis labels, and other formatting options. This could ease interpretation for trading purposes.
Conclusion
In this article, we have answered the question, of what is stochastic, and pointed out the utility it offers to tens of millions of traders worldwide that rely on momentum-based indicators.
As a technical tool, the stochastic approach is highly reliable in pointing out when a stock is overbought or oversold. It shares a number of similarities with the Relative Strength Index (RSI). The beauty of this tool lies in how easily it can be adopted by even the most beginner of traders.
When used in conjunction with other tools, such as support and resistance, or candlestick patterns, market players stand to gain a tremendous edge over the wider market, and can proactively pick out trend reversals or continuations, before they even play out.
