Stochastics is one of the most used technical indicators in the analysis of the security trends. Developed more than a half of century ago this indicator shows how far away is the current security price is from the most recent low and high.
For instance, Stochastics (7) means that seven last bars are analyzed to define the current position of the price in relation to the high-low range of these 7 bars. When the Stochastics (7) on the daily chart (1 bar = 1 day) is close to zero line it tells us that the current price is at lowest levels over the last seven days. If the same
Stochastics line on the same chart is close to 100 it tells us that the current price is at the highest levels over the last 7 days. The theory of
technical analysis states that when Stochastics moves below 20 it point to the oversold market and when the Stochastics is above 80 it suggested an overbought market. Yet, you should be careful with fast conclusion. If the Stochastics below 20 it does not imply that you will see trend reversal. It simply shows you that the price is close to the 7-day lows. To come to this lows your stock could go down for 7 straight days in a row, it could move flat and modestly lower on the seventh day, it could go one day strongly down and then 6 days flat, etc. There could be number of situations how your security could come to the 7-day low and it does not imply that your stock will move up because of that.
Does it mean that the Stochastics is bad technical indicator? No, it would be wrong conclusion. Stochastics is good technical indicator and all you have to do is to understand what it shows and how to use it. It is recommended to monitor this indicator for the moments when it moves above 20 after being below this level and for the moments when it moves down below 80 after being above this level. These moments are considered better
trading signals then the moments when Stochastics just drop below 20 and run above 80.
When Stochastics crosses 20 after being below it mean the price started to rise after hitting some bottom. It still does not guarantee that the price will continue to move up, yet it shows that sentiment has changed and there is a possibility that it will stay this way. In many cases it’s true and you may anticipate for some move up.
The same as with other technical indicators it is recommended to monitor the volatility of your security because indicator's setting depends on it. At the same time it could be a good practice to use this indicator in union with others. Since Stochastics is based solely on price it is recommended to use it in combination with volume based technical analysis.
