The Ultimate Way to Read a Stochastic Signal

by Donald Harder

As with any stock indicator, the stochastic can offer reliable buy and sell signals if read properly, but can lead to huge mistakes if you do not take into account the bigger picture. To read a stochastic indicator you must first determine the trend of the stock.

Stochastic Signals and the Trend

The stochastic indicator behaves differently, depending on whether the stock you are measuring is trending and, if so, the direction it is trending. First, understand that a stock is not necessarily trending. In fact, most stocks spend only a small portion of their time trending (perhaps 30%) and they spend the rest of their time in trading ranges where they directionlessly oscillate between support and resistance levels.

Reading the Stochastic for Stocks in a Trading Range

When a stock is in a trading range, the stochastic works in a fairly straightforward fashion. As you can see on the $APD chart, when the stochastic line is below 25, indicating the stock is oversold, it produced reasonably accurate buy signals. Likewise, when the stochastic line was above 75, indicating the stock price was overbought, it produced accurate sell signals.

Reading Stochastic Signals in a Downtrend

When a stock is in a steep downtrend the way $NFLX was this year, the stochastic indicator behaves quite differently. Note that when the stochastic line was below 75 the price continued lower for extended periods of time. Buying $NFLX simply because the stochastic reading showed the price was oversold would have caused you to lose money on virtually every trade you made. Also note that because the trend was so steeply lower, the stochastic line had difficult rising above 50 before it reversed back into oversold territory. In this case, the stochastic indicator does not offer reliable trade signals and can be used merely to confirm the trend.

Reading Stochastic Signals in an Uptrend

When a stock is in an uptrend, like $MCD has been most of this year, the stochastic reads much like a stock in a downtrend, but in reverse. The stochastic line remained in overbought territory for extended periods of time, yet the price continued to inch higher, causing traders reading the signal improperly to sell early when in fact they should have read this as a confirmation of the uptrend.