Stochastics Used in Technical Analysis

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Understanding Stochastics Fast and Slow

The Stochastic technical analysis indicator might be helpful in detecting price divergences and confirming trend. Here are the the basics.

Stochastic Fast

Stochastic Fast plots the location of the current price in relation to the range of a certain number of prior bars (dependent upon user-input, usually 14-periods).

In general, stochastics are used in an attempt to uncover overbought and oversold conditions.

Above 80 is generally considered overbought and below 20 is considered oversold.

The inputs to Stochastic Fast are as follows:

  • Fast %K: [(Close – Low) / (High – Low)] x 100
  • Fast %D: Simple moving average of Fast K (usually 3-period moving average)

Stochastic Slow

Stochastic Slow is similar in calculation and interpretation to Stochastic Fast. The difference is listed below:

  • Slow %K: Equal to Fast %D (i.e. 3-period moving average of Fast %K)
  • Slow %D: A moving average (again, usually 3-period) of Slow %K

The Stochastic Slow might be viewed as superior due to the smoothing effects of the moving averages which equates to less false potential buy and sell signals.

A comparison of the two stochastics, fast and slow, is shown below in the chart of the Nasdaq 100 ETF (QQQQ):

Comparison of Stochastic Fast and Stochastic Slow

The next few sections discuss possible buy and sell signals and how stochastics may outline areas of overbought or oversold price conditions.

Stochastics Buy & Sell Signals

Stochastics Potential Buy Signal

A trader might interpret a buy signal when the Stochastic is below the 20 oversold line and the %K line crosses over the %D line.

Stochastics Potential Sell Signal

A trader might interpret a sell signal when the Stochastic is above the 80 overbought line and the %K line crosses below the %D line, sell.

An example of possible Stochastic Fast buy and sell signals are illustrated below in the chart of the E-mini S&P 500 Future:

Stochastic Fast buy and sell signal

Stochastic Slow is presented below in the chart of the E-mini Russell 2000 Futures contract.

Notice how much smoother the %K and %D lines are and how many fewer false signals were given by the Stochastic Slow than were given by the Stochastic Fast indicator.

Stochastic Slow buy and sell signal

The Stochastic technical analysis indicator might be helpful in detecting price divergences and confirming trend. This is discussed in the next section.

Stochastic Price Divergences

Stochastics might be used by a trader to confirm price trend. In the example below of the Nasdaq 100 ETF (QQQQ), the Stochastic indicator spent most of its time in an overbought area.

When Stochastics get stuck in the overbought area, like at the very right of the chart, this might be a sign of a strong bullish run.

Signals to sellshort might be ignored by a trader; however, before the signal not to short was given, many losses may have accrued from failed shorting attempts on the left half of the chart.

Stochastic pinned above overbought area

The chart below of Gold futures illustrates Stochastic divergences and confirmations:

Stochastic price divergences

Low #1 to Low #2

The Stochastic Slow confirmed the upward movement of gold futures prices by making a higher low.

High #1 to High #2

Gold futures rallied to make a higher high; however, the Stochastic Slow indicator failed to make a higher high, instead it made a lower high.

This divergence coupled with a trendline break in the price of gold may have acted as a strong warning to futures traders that the recent rally had probably ended and any long futures positions might be exited or at least scaled back.

Low #3 to Low #4

Gold prices continued its downward tumble, making a lower low at Low #4. On the other hand, the Stochastic Slow indicator was signaling a higher low.

This bullish divergence may have warned traders to exit their shortsells, traders may have interpreted that the price of gold had a strong potential of bottoming.

Also see Stochastic RSI.

How to Get Started Trading

If you are interested in trading using technical analysis, have a look at our reviews of these regulated brokers available in to learn which charting & analysis 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 73.90%-89.00% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.

Further Reading

Learn more about technical analysis indicators, charting concepts, and strategies including MomentumMarket Thrust, the Advanced Decline Ratio, Moving Averages, Exponential Ribbons, and Average Directional Movement.

If you’d like a primer on how to trade commodities in general, please see our introduction to commodity trading here.

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