It is always useful and sometimes critical to know if a stock trend is going to continue or suddenly reverse. Over the long haul, staying invested in a secure, dividend-paying investment generally results in profits. However, you can make a lot more money on a good stock if you buy at the bottom after a market crash. Also, you really do not want to jump into a stock just to see it peak and head downward. There are ways to help an investor anticipate when the market will turn. One of them is with stochastic indicators. How do stochastics help your investing?
What Are Stochastic Indicators?
Stochastic processes have to do with probability theory. They are used for investigating things like populations of bacteria, movement of gas molecules, and how electrical current varies with “thermal noise.” This is all very nice but was of no use to stock traders until the 1950s when George Lane adapted a simplified stochastic approach to stocks. Specifically, Lane developed a way to help determine if a given stock or the whole market is overbought or oversold. In other words, he helped investors see if a trend was about to reverse.
Where Is a Stochastic Indicator Useful?
Long term investors will generally not use a stochastic oscillator on a day by day, week by week or even month by month basis. They are more likely to use an approach like dollar cost averaging to limit their purchases when stocks are expensive and buy more when stocks are relatively cheap. Because a stochastic indicator helps tell you if an upward or downward trend is about to reverse, that is especially where this technical indicator can be useful for an investor who more commonly uses intrinsic stock value as a guide rather than technical indicators.
When the Financial Crisis drove the market down, the S&P 500 went from a peak of 1530 to a bottom of 735. Anyone who just stayed invested in an ETF that tracked the S&P 500 did OK as the index is at 4320 today. But anyone who recognized when the market was oversold at the bottom and bought then did twice as well. Every time that the market corrects, there are similar buying opportunities when selling turns to buying at the bottom and prices head back up. Likewise, there are times when recognizing when the market has topped out is useful as one can wait for more rational pricing before buying again.
How Does a Stochastic Oscillator Work?
A stochastic oscillator measures recent stock prices and ranks them on a scale of zero to one hundred. Anything over eighty suggests that the stock is overbought. Anything below twenty indicates an oversold situation. A trader will follow both the stock price and the oscillator value on their charts. A useful signal in a bear market is when the stock hits a new low and the oscillator shows a low that is somewhat higher. This is typically an indication that the downward trend is losing momentum, and the oversold situation is close to reversing.
Don’t Rely on Just Stochastics
Those who routinely use a stochastic oscillator combine it with at least one other technical indicator such as a moving average. Technical indicators are often useful when the market panics or when it gets really exuberant. But those are not times to totally forget about fundamentals. Companies that are making money despite a recession and market crash (like Coca Cola) are always good investments. And companies that will continue to make more money afterwards (like Microsoft) are even better ones as their stock prices fall with a panicked market. The value of a stochastic oscillator for long term investors is to help pick up bargains as the market falls and warn you off of buying when greed is driving prices higher and higher.
Do Stochastics Help Your Investing? – SlideShare Version