Importance of the stochastic indicator in technical analysis
A guide to technical indicators, Dow Theory, and Elliott Wave Theory (Part 5 of 14)
Stochastic indicator
The stochastic indicator compares the stock’s closing price with the stock’s price over a certain time period. In an uptrend, the stock price tends to close near its high. In a downtrend, the stock price tends to close near its low.
The above chart shows the stochastic indicator for General Motors’ (GM) stock.
Stochastic calculation
The stochastic indicator moves between zero and 100 levels. A 14-day time period is commonly used. However, the number of days can be customized. The indicator has two lines—the %K line and the %D line. The %K line is the faster line. The %D is the slower line.
%K = 100 (closing price – lowest price in the last 14 days)/(highest price in the last 14 days – lowest price in the last 14 days)
and
%D = average of the last three %K values calculated daily
For the stochastic indicator, the level of 20 is considered oversold. The level of 80 is considered overbought. When the stock is oversold and at the support level, it could be used as an entry point. When the stock is overbought and at the resistance level, it could be used as an exit point.
The stochastic indicator uses the stock’s relative closing prices to calculate the oversold and overbought levels. The Relative Strength Index (or RSI) uses the ratio of average gain and loss to calculate the overbought and oversold levels. An oversold level is 30 in RSI and 20 in stochastic. The overbought level is 70 in RSI and 80 in stochastic. Both indicators have minor differences. However, their functions are the same. They determine the stock’s strength.
It isn’t recommended to use the stochastic indicator alone for an entry and exit strategy. It’s advisable to use a combination of indicators and patterns for entry and exit signals.
Applying stochastic concepts
In technical analysis, stochastic concepts can be applied to stocks like Duke Energy (DUK), Southern Company (SO), and American Electric Power Company (AEP). These companies are part of the Utilities Select Sector SPDR (XLU). XLU is a key exchange-traded fund (or ETF) in the power utilities industry.
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