Stochastics: An Accurate Buy and Sell Indicator
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Updated July 31, 2023
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In the late 1950s, George Lane developed stochastics, an indicator that measures the relationship between an issue’s closing price and its price range over a predetermined period of time. To this day, stochastics are a favored technical indicator because they are fairly easy to understand and have a good track record in terms of accuracy for indicating whether it’s time to buy or sell a security.
Key Takeaways
- Stochastics are a favored technical indicator because they are easy to understand and have a relatively high degree of accuracy.
- It falls into the class of technical indicators known as oscillators.
- The indicator provides buy and sell signals for traders to enter or exit positions based on momentum.
- Stochastics are used to show when a stock has moved into an overbought or oversold position.
- it is beneficial to use stochastics in conjunction with other tools like the relative strength index (RSI) to confirm a signal.
Price Action
The premise of stochastics is that when a stock trends upwards, its closing price tends to trade at the high-end of the day’s range. For example, if a stock opened at $10, traded as low as $9.75 and as high as $10.75, then closed at $10.50 for the day, the price action or range would be between $9.75 (the low of the day) and $10.75 (the high of the day). Conversely, if the price has a downward movement, the closing price tends to trade at or near the low range of the day’s trading session.
Stochastics is used to show when a stock has moved into an overbought or oversold position. Fourteen is the mathematical number most often used in the time mode. Depending on the technician’s goal, it can represent days, weeks, or months. The chartist may want to examine an entire sector. For a long-term view of a sector, the chartist would start by looking at 14 months of the entire industry’s trading range.
The stochastic indicator is classified as an oscillator, a term used in technical analysis to describe a tool that creates bands around some mean level. The idea is that price action will tend to be bound by the bands and revert to the mean over time.
Relative Strength Index (RSI)
An example of such an oscillator is the relative strength index (RSI)—a popular momentum indicator used in technical analysis—which has a range of 0 to 100. It is usually set at either the 20 to 80 range or the 30 to 70 range. Whether you’re looking at a sector or an individual issue, it can be very beneficial to use stochastics and the RSI in conjunction with each other.
Formula
Stochastics is measured with the K line and the D line. But it is the D line that we follow closely, for it will indicate any major signals in the chart. Mathematically, the K line looks like this:
where:
CP=Most recent closing price
L14=Lowest price of the 14 previous trading sessions
H14=Highest price of the same 14 previous trading sessions
The formula for the more important D line looks like this:
D = 100 ( H 3 L 3 ) where: H 3 = Highest of the three previous trading sessions L 3 = Lowest price traded during the same three-day period begin&text = 100bigg(fracbigg) \&textbf \&H3 = text\&L3 = text\&qquadtext< , period>end D = 100 ( L 3 H 3 ) where: H 3 = Highest of the three previous trading sessions L 3 = Lowest price traded during the same three-day period
We show you these formulas for interest’s sake only. Today’s charting software does all the calculations, making the whole technical analysis process so much easier, and thus, more exciting for the average investor.
%K is sometimes referred to as the fast stochastic indicator. The «slow» stochastic, or %D, is computed as the 3-period moving average of %K.
Reading the Chart
The K line is faster than the D line; the D line is the slower of the two. The investor needs to watch as the D line and the price of the issue begin to change and move into either the overbought (over the 80 line) or the oversold (under the 20 line) positions. The investor needs to consider selling the stock when the indicator moves above the 80 levels. Conversely, the investor needs to consider buying an issue that is below the 20 line and is starting to move up with increased volume.
Over the years, many articles have explored «tweaking» this indicator. But new investors should concentrate on the basics of stochastics.
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In the chart of eBay above, a number of clear buying opportunities presented themselves over the spring and summer months of 2001. There are also a number of sell indicators that would have drawn the attention of short-term traders. The strong buy signal in early April would have given both investors and traders a great 12-day run, ranging from the mid $30 area to the mid $50 area.
What Are Stochastics?
In technical analysis, stochastics refers to a group of oscillator indicators that point to buying or selling opportunities based on momentum. In statistics, the word stochastic refers to something that is subject to a probability distribution, such as a random variable. In trading, the use of this term is meant to indicate that the current price of a security can be related to a range of possible outcomes, or relative to its price range over some time period.
How Can I Use Stochastics in Trading?
The stochastic indicator establishes a range with values indexed between 0 and 100. A reading of 80+ points to a security being overbought, and is a sell signal. Readings 20 or lower are considered oversold and indicate a buy.
What Is a Stochastic Stock Chart?
Technical traders can add the stochastic oscillator on top of a security’s price chart, which often appears in its own window below the price. There will typically be a horizontal line drawn at the 80 and 20 levels of the index as well as at the mean (50). When the stochastic line falls below 20 or rises above 80, it produces a trading signal.
How Do You Make Stochastic Charts With Excel?
If you have data on the closing prices of a security, you can import that into Excel in order to compute %K. In particular, you would subtract the highest high observed in your lookback period from the last closing price and put this into the numerator of a fraction. In the denominator, you would take the difference between the highest high and lowest low prices over that same period. Then, multiply by 100.
The Bottom Line
Stochastics is a favorite technical indicator because of the accuracy of its findings. It is easily perceived both by seasoned veterans and new technicians, and it tends to help all investors make good entry and exit decisions on their holdings.
When To Use And How To Read The MACD Indicator
This technical analysis guide explains what the moving average convergence divergence indicator (MACD) is, and how traders use it to exercise trading strategies.
We explore what the MACD indicator looks like on an example chart and how you can read it to gain trading insights.
- What Is The MACD Indicator?
- How To Read MACD Moving Average Crossovers
- How To Read A MACD Histogram
- What Are MACD Divergences?
- Where Can I Start Trading And Using MACD?
- FAQs
- Further Reading
Read on to learn about moving average crossovers, buy and sell signals, the MACD histogram, and divergences.
What Is The MACD Indicator?
The MACD indicator, also known as the MACD oscillator, is one of the most popular technical analysis tools.
There are three main components of the MACD shown in the picture below:
- MACD: The 12-period exponential moving average (EMA) minus the 26-period EMA.
- MACD Signal Line: A 9-period EMA of the MACD.
- MACD Histogram: The MACD minus the MACD Signal Line.
Ways To Interpret The MACD Index
The MACD indicator is a versatile tool. There are three main ways to interpret the MACD technical analysis indicator, discussed in the following three sections:
- Moving Average Crossovers
- MACD Histogram
- MACD Divergences
How To Read MACD Moving Average Crossovers
The primary method of interpreting the MACD is with moving average crossovers.
When the shorter-term 12-period exponential moving average (EMA) crosses over the longer-term 26-period EMA a potential buy signal is generated.
Important: The difference between short-term moving averages and long-term moving averages is that short-term MAs are used for smaller time-frames to find the moving average, while long-term MAs are used for wider time-frames. The underlying function is the same.
This is seen on the Nasdaq 100 exchange traded fund (QQQQ) chart below with the two purple lines.
Remember that the MACD line (the blue line) is created from the 12-period and 26-period EMA. Consequently:
- When the shorter-term 12-period EMA crosses above the longer-term 26-period EMA, the MACD line crosses above the Zero line.
- When the 12-period EMA crosses below the 26-period EMA, the MACD line crosses below the Zero line.
How To Use Moving Average Crossover To Spot Buy Signals
A possible buy signal is generated when the MACD (blue line) crosses above the zero line.
How To Use Moving Average Crossover To Spot Sell Signals
When the MACD crosses below the zero line, then a possible sell signal is generated.
The prior potential buy and sell signals might get a person into a trade later in the move of a stock or future.
Another potential buy and sell signal is shown in the graph above in the Nasdaq 100 exchange-traded fund QQQQ chart.
Most Common MACD Potential Buy and Sell Signals
Traders get valuable insight from the MACD in the form of potential buy and sell signals.
How To Read A Potential MACD Buy Signal
A potential buy signal is generated when the MACD (blue line) crosses above the MACD Signal Line (red line).
How To Read A Potential MACD Sell Signal
Similarly, when the MACD crosses below the MACD Signal Line a possible sell signal is generated.
The MACD moving average crossover is one of many ways to interpret the MACD technical indicator. Using the MACD histogram and MACD divergence warnings are two other methods of using the MACD.
How To Read A MACD Histogram
The MACD Histogram is simply the difference between the MACD line (blue line) and the MACD signal line (red line). The MACD histogram is illustrated in the chart below of the Nasdaq 100 QQQQ’s:
Two important terms are derived from the MACD histogram and are illustrated in the QQQQ chart above:
What Does The MACD Convergence Show?
The MACD histogram is shrinking in height. This occurs because there is a change in direction or a slowdown in the stock, future, bond, or currency trend.
When that occurs, the MACD line is getting closer to the MACD signal line.
What Does The MACD Divergence Show?
The MACD histogram is increasing in height (either in the positive or negative direction).
This occurs because the MACD is accelerating faster in the direction of the prevailing market trend.
Shrinking MACD Histogram: What Does It Mean?
When a stock, future, or currency pair is moving strongly in a direction, the MACD histogram will increase in height.
When the MACD histogram does not increase in height or begins to shrink, the market is slowing down and might be warning of a possible reversal.
If you already understand how to use the MACD index, you can explore some of our commodity guides to find a suitable asset to practice with, like precious metals, energies, and agricultural commodities. Alternatively, you can see our stock trading guide.
The graph below of the E-mini Nasdaq 100 Index Future shows this phenomenon:
How To Find The Peak And Trough
The letter “T” represents when the top or peak of the moving average convergence divergence histogram occurs. In contrast, the letter “B” shows when the bottom of the MACD histogram occurs.
Notice in this example how closely the tops and bottoms of the MACD histogram are to the tops of the Nasdaq 100 e-mini future price action.
Potential Buy Signal With MACD Histograms
When the MACD histogram is below the zero line and begins to converge towards the zero line.
Potential Sell Signals With MACD Histograms
When the MACD histogram is above the zero line and begins to converge towards the zero line.
Note: In the above example, three consecutive days of the shrinking MACD histogram from top or bottom served as possible buy or sell signals, these are shown with arrows.
This is an aggressive example. A trader might wait until the MACD histogram went to zero, but that would be the same signal as the MACD moving average crossover.
In addition to signaling, potential buy or sell signals, the moving average convergence divergence could be used for warnings of potential change in the direction of stocks, futures, and currency pairs.
What Are MACD Divergences?
Divergences might signal a trader to get out of a long or short position before profits erode.
- Bearish divergence occurs when a technical analysis indicator is suggesting that a price should be going down but the price of the stock, future, or currency pair is continuing to maintain its current uptrend.
- Bullish divergence occurs when the indicator is indicating that price should be bottoming and heading higher, yet the actual price action is continuing downward.
How To Read High #1 to High #2
Looking at the E-mini S&P 500 future, from High #1 to High #2, the futures contract made higher highs, which is usually viewed as bullish. However, the MACD moving average failed to make a new high.
This bearish divergence acted as an early warning sign of things to come with the E-mini S&P 500 futures contract.
How To Read Low #1 to Low#2
In yet another bearish sign for the E-mini S&P 500 futures contract, the future made higher lows from Low #1 to Low #2, which again is usually considered positive.
Nevertheless, the MACD technical indicator made a clear lower low from Low #1 to Low #2. This bearish divergence warned of the impending downturn of the S&P 500 future and the market as a whole.
How To Read Low #2 to Low #3
In addition to bearish and bullish divergences, the MACD might confirm price movement as well.
The E-mini S&P 500 futures contract made a substantial lower low which was confirmed by the MACD when it made a lower low as well.
As seen throughout the MACD sections, the moving average convergence divergence is a versatile tool giving a trader possible buy and sell entries and giving warnings of potential price changes.
Where Can I Start Trading And Using MACD?
If you are interested in trading using technical analysis, have a look at our reviews of these regulated brokers in to learn which charting tools they offer:
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CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74%-89% of retail investor accounts lose money when trading CFDs. You should consider whether you can afford to take the high risk of losing your money.
FAQs
Who invented the MACD?
The moving average convergence divergence (MACD) index was invented by Gerald Appel in the 1970s. Appel designed the MACD as a technical analysis tool to gain insight on stock prices, with the intent to reveal data about the stock’s momentum, strength, as well as directional assumptions.
What is the difference between MACD and RSI?
While the moving average convergence divergence (MACD) indicator measures the difference between two separate exponential moving averages (EMAs), the relative strength index (RSI) measures the difference in selected price highs and lows in a chart. These technical analysis tools are used together by traders.
What is the best time frame for MACD?
There is no one best time frame to use the MACD index in. The MACD provides insight on potential divergence within any given time frame on a chart. The best time frame to use with the MACD depends on the type of trade, instrument, and stock that you’re interested in creating and executing a strategy for.
Further Reading
You can explore other technical oscillators, like:
- Ultimate Oscillator
- Price Oscillator
- Detrended Price Oscillator
- Volume Oscillator
- Chaikin Oscillator
If you’d like a primer on how to trade commodities in general, please see our introduction to commodity trading, our guides on trading specific instruments like CFDs, forex, cryptocurrencies, stocks, and options.
Written by
Lawrence Pines is a Princeton University graduate with more than 25 years of experience as an equity and foreign exchange options trader for multinational banks and proprietary trading groups. Mr. Pines has traded on the NYSE, CBOE and Pacific Stock Exchange. In 2011, Mr. Pines started his own consulting firm through which he advises law firms and investment professionals on issues related to trading, and derivatives. Lawrence has served as an expert witness in a number of high profile trials in US Federal and international courts.
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