An Overview of the Stochastics Indicator

Indicators are an important part of the trader’s toolkit, especially when you learn to appropriately use the indicators which are available to you. However, many people look at indicators as a "signal" that says "buy now" or "sell now." For most people, they are looking for that buy/sell signal, and when they see it, they enter the trade. This is known as "following an indicator." The good news is sometimes it works. The bad news is sometimes it doesn't.

The Real Function of Indicators

Indicators are useful for two things:

  • ​They will confirm what you already knew about a trade.
  • ​They will alert you to something you did not see.

You can equate indicators to the gauges in your car. For example, could you drive across town with no gas gauge? Of course, you could. Could you make your way across the country without a speedometer? Yes, it is possible. Indicators do not drive the trade any more than gauges drive the car. Yet many people try to follow indicators as though they were the most important factor of the trade.

Take, for example, your gas gauge. Most of the time, you look at your gas gauge, and it tells you that you still have plenty of gas. Or maybe you think to yourself "hmm, it's been a while since I got gas, I should check and see, yep I'm getting a little low." And now and then, we forget to check the gas gauge and look only to realize we are out of gas.

In that case, my gas gauge alerted me to something I didn't realize. Sure, if I had put more thought into it, I could have remembered that I needed gas, but I didn't put thought into it, and I was thankful to have my gas gauge.

Stock market indicators are very similar. If you look at a stock and think "yea, that stock has been trending quite a while, it looks like it should probably give a small correction soon," and then you look at your indicators and discover they are overbought. Your thought is "yes, that's just as I expected, this stock is overbought."

However, sometimes you may think "oh this trend has a long way left to rally" but when you look at your indicator you see "oh no, this indicator has already turned down, maybe I shouldn't be buying this stock." If you can follow this metaphor on how indicators work, then you will be well ahead in your use of indicators.

Indicators are not the most important piece of information, and they are not the ideal buy/sell signal.

Indicators are a great tool to help confirm what you already knew or alert you to something you did not see.

Some Signals Are More Important

Another thing to consider is this - Some signals are simply more important than others.

Imagine you are driving your vehicle down the road, and your gas light comes on. Okay, no problem, you probably have 20-30 miles before you run out of gas. So, is it urgent to pull over and get gas? Well it's important, but it's not dire yet.

Now imagine you're driving down the road, and your temperature gauge shows you're in the red. Is it urgent to pull over? Yes! You do not want to continue driving with your car, potentially overheating, the damage could be catastrophic. Thus, some signals are more urgent than others. Similarly, some indicator signals are more important.

For example, if you see a stock has reached overbought or oversold, it may mean that in the near future, that trade is going to swing the other direction. But what if you see a divergence signal?

Divergence is kind of like your car overheating. You don't want to mess with it. That's a signal to definitely start tightening up your stops and maybe get out of the trade because this trend is quite possibly ready to turn around on you.

Understanding the function of indicators, to confirm or alert, and understanding that some signals are more important than others is the most important part of understanding how indicators work. If you understand these two components, everything else becomes simple.

Indicators are one of the greatest tools we have in our trading toolkit. You have to know how to use them. Some indicators are so accurate and consistent; it is tempting to think everything I have just shared with you doesn't apply. It's tempting to follow right along with some indicators, but you would be much better served to learn how to use them.

An Indicator that Loves to Perform

The Stochastics indicator is one that loves to perform year after year, decade after decade. This indicator was created by George Lane in the 1950s. And it has been a favorite ever since.

There are three main signals we can take from the stochastics indicator:

  • ​Overbought/Oversold
  • Divergence
  • Buy/Sell Signals

Let’s breakdown the Stochastics indicator:

The stochastics indicator is made up of two lines. When one line crosses the other, it is a signal to buy or sell the security it is tracking. Take a look at the image below:

You will also notice there is a horizontal line running across the top and bottom. These mark the overbought at the top and oversold at the bottom levels. When the stochastics reach oversold and cross up, it is a buy signal. When they reach overbought and cross down, it is a sell signal.

Now there's another important thing to consider. Stochastics is what we call "range-bound". That means it can't trade higher than its upper limit of 100 or lower than its lower limit of 0. This range-bound setup allows for the indicator to oscillate back and forth with the momentum of the stock. When a trend has gone a long way in one direction, the indicator keeps maxing out. But the second that momentum lets up, the indicator will give a strong signal that this trade is done. It works beautifully.

Riding the Channel

For the last six months, the market has been stuck. It's not going up and not going down. It will start down, then in just 2-3 sessions it seems to have recovered all its losses. Then it will kind of start to break out to the upside and boom; in 3-4 sessions it has given back all of its gains. This is a very frustrating market situation. We have a name for this type of market. It's called "a consolidation" and one pattern that emerges during a lot of consolidation periods is what we call a channel.

This is an example of a channel:

You can see how the trade keeps moving from support up to resistance and back down to support.

This type of trade can be frustrating, particularly if you're using indicators that are useful primarily for trending markets such as moving averages. Here is where stochastics shine. The combination of everything I have said already about stochastics, the fact it's got the two buy/sell lines, the overbought/oversold indication, and the reality that its range-bound - makes this the perfect indicator for a sideways trading channel.

It is this simple. When a stock gets stuck in a sideways channel, look at your stochastics. When stochastics cross down, short the trade, and when they start crossing over flip your position to a long trade.

Some channels will last months, and some can last more than a year. If you're waiting for a good trend you may be waiting a long time, but by using your stochastics indicator and trading the inside range of the channel, you can pull out consistent profits typically about every few weeks.

​Wrap Up

If you approach indicators as a tool for confirming what you already knew or alerting you to something you didn't see, and if you'll pair up your indicators for ideal situations such as the Stochastics in a sideways channel, you will certainly discover that you don't need that secret indicator. The best indicators are still the free ones that have been around for years, and you have to learn use them to their maximum effect.