Section: 3 Market Structure

Sub Section: 3 Stochastic Indicator

When a trend is upward there is a tendency that the close price will be very close to that day's high. During a downward trending market there is a tendency that the close price is closer to the low price. The Stochastic Indicator helps to find trend reversal by searching for a period when: the close prices are close to low prices in an upward trending market; or close prices are close to high prices in a downward trending market. This formula has two output values: %K - Simple Stochastic Indicator and %D - Smoothed Stochastic Indicator (Moving Average of %K). An example is illustrated graphically as follows:

Readings below 20 are considered oversold and readings above 80 are considered overbought. However, a security can continue to rise after the Stochastic Oscillator has reached 80 and continue to fall after the Stochastic Oscillator has reached 20.

Buy and sell signals can also be given when %K crosses above or below %D. However, crossover signals are quite frequent and can result in a lot of whipsaws.

One of the most reliable signals is to wait for a divergence to develop from overbought or oversold levels. Once the oscillator reaches overbought levels, wait for a negative divergence to develop and then a cross below 80. This usually requires a double dip below 80 and the second dip results in the sell signal. For a buy signal, wait for a positive divergence to develop after the indicator moves below 20. After the positive divergence forms, the second break above 20 confirms the divergence and a buy signal is given.