Momentum studies include Stochastics, RSI, TSI, MACD, and Rate of Change. While each momentum study has a different presentation, there are three areas of interpretation that are shared: divergence; trend; and absolute value (in order of importance). The following discussion of Stochastics applies in general to all momentum studies. If you can learn to spot divergence and trend on one momentum study, you have mastered the use of all.
Markets that are heading higher tend to close nearer the high than the low with the reverse being true in markets that are heading lower. This is what Stochastics is attempting to measure. While there are many ways to interpret this momentum study, the most accurate is to look for price divergence. When price patterns are making higher tops while Stochastics is making lower tops, this is called bearish divergence. As the name implies, this is a sell signal. Conversely, when the price pattern is making lower bottoms and Stochastics is making higher bottoms, this is bullish divergence (see the arrows on the chart below)
The formula for stochastics looks like this...
Fast %K = ((Close-Low in Period)/(High in Period-Low in Period))*100
Slow %k = Moving average (user selectable) of Fast %K
%d = Moving average (user selectable) of Slow %k
The stochastics formula produces numbers that are between 0 and 100. Fast Stochastics uses the first two values while slow Stochastics use the latter two. Analyst can plot slow or fast stochastics or all three lines. All values that are not assigned the same color as the background color will be displayed. We are using a 20,3,3 slow Stochastics in our example. 20 is the period used to calculate fast %K, slow k% is a 3 period moving average of fast %K and %d is a 3 day moving average of slow k%. All three parameters are user adjustable. Clicking on any point in the chart displays the stochastics values for that point. In simplistic terms, Stochastics is considered oversold when %k is under 25 and is crossing over above %d and overbought when it exceeds 75 and crossing under %d. As crossovers often occur with no change in price trend the skilled analyst will filter out false signals. Divergence is the best filter. As mentioned earlier, when price patterns are making higher tops while Stochastics is making lower tops, this is called bearish divergence. As the name implies, this is a sell signal. Conversely, when the price pattern is making lower bottoms and Stochastics is making higher bottoms, this is bullish divergence. A second filter for this indicator is the trend of the %d line. In our example you could draw a trend line connecting the dips in mid December, late January and most recently in mid April. A third filter would be to look for signals generated by other indicators to act as confirmation or denial of the signal presented by Stochastics.