Identify overbought and oversold stocks with stochastic oscillators

How many of you have a habit of checking 52-week high and low before buying a stock?

Just knowing the range of the stock conveys nothing, unless, you can derive actionable insights thereof.

This is where stochastic oscillators can come to your rescue.

What’s a stochastic oscillator?

A stochastic oscillator (we’ll call it stochastics from here on) is a momentum indicator that helps you understand the underlying price trend. If used correctly, you can identify overbought and oversold trade positions with stochastic.

Getting down to brass tacks, it could help you decide on what short term position to take.

What’s behind stochastics?

This indicator is based on the assumption that in a market trending upward, prices will close near the high (and that’s fair enough, if you think about it), and in a market trending downward, prices close near the low (again, a regular expectation).

Setting up stochastic charts

Charting for stochastics involves two lines: one reflecting the actual value of the oscillator for each session (called %K), and one reflecting its three-period simple moving average (called %D).

%K is the current value of stochastics based on the price range for a given number of time periods; say 5/days/weeks/months or 14 days/weeks/months and so on.

You may never need to calculate these, as they available on any technical software worth a mention, but we’ve included a quick lowdown on how they are constructed at the end of the article, for those interested.

The value of the oscillator (%K) is range-bound, due to its construct, and its swings between zero and 100. Being its three periods moving average, %D also ranges between 0 and 100.

Reading the signals

As a rule of thumb, higher values of %K and %D indicate a tendency to overbought conditions and lower values imply the possibility of an oversold situation.

Further, being a momentum indicator, there are times when %K is above %D and vice versa at other times.

Stochastics generate buy signals when: the %K line crosses overs the %D line and %D line is in the oversold zone, i.e. the value is below 30 or preferably below 15.

There’s a positive divergence between the stock price trend and the stochastic trend wherein the scrip forms lower tops while %D line forms higher tops and %K line crosses above %D line.

 On the other hand stochastics generate a sell signal when: the %K line crosses below the %D line and the %D line is in the overbought zone, i.e. the value is above 70 or preferably above 85.

There’s a negative divergence between the stock price trend and the stochastic trend wherein the scrip forms higher tops while %D line forms lower tops and %K line crosses below %D line.

What do stochastic charts look like?

Stochastic: Generating reliable indicators?

Have a look at the chart above.

The two black horizontal lines, at 70 and 30, represent the thresholds of the overbought and oversold zones, respectively.

On the other hand, the red horizontal lines represent extremely overbought and oversold zones at 85 and 15, respectively.

Like we said earlier, when the %K line moves below the %D line in the overbought zone, preferably above the 85 mark and the %D line also starts moving downward from the overbought zone, it’s a signal to sell, which should be confirmed by the price chart.

On other hand, when the %K line crosses the %D line in the oversold zone, preferable below the 15 mark and the %D line also starts moving upward from the oversold zone, it’s a signal to buy, which should be confirmed by the price chart.

Now let’s get real

Look at this chart.

In the graph above, the green line represents %K and the red line represents %D.

On July 20th, 2018, %K trended upwards and %D also started showing signs of bottoming out. The stock was in the oversold zone. Thus, stochastics generated a buy signal at Rs 293. Subsequently, the sell signal was generated when the %K line crossed below the %D line when the stock was in the overbought zone on the stochastic chart. The stock quoted at Rs 381.

On February 15th, 2019, once again the stochastics generated a buy signal at Rs 256 when %K crossed above %D and the stock was in the oversold zone, going by the movement of stochastics.

And that’s how it works!

To improve your trading experience, you should follow other technical indicators too, which include Moving Average Convergence and Divergence (MACD) and Relative Strength Index (RSI).