What is Stochastic
Stochastic is an oscillator that measures overbought and oversold conditions in the market. The 2 lines are similar to the MACD lines in a sense that one line is faster than the other. These 2 lines are known as %K and %D. %K is the main (fast) line and %D is the signal (slow) line. The figure below shows the main (fast) line in blue and the signal (slow) line in red.
The formula of the Stochastic lines:
Fast %K = ((Current Close – Lowest Low in %K Periods) / (Highest High in %K Periods – Lowest Low in %K Periods)) * 100
Slowing %K = N-period moving the average of Fast %K
%D = N-period simple moving average of Slowing %K
How to Apply Stochastics?
Stochastics tells us when the market is overbought or oversold. Stochastics are scaled from 0 to 100. When the stochastic lines are above 80 (the red dotted line in the chart above), then it means the market is overbought. When the stochastic lines are below 20 (the blue dotted line), then it means that the market is oversold. As a rule of thumb, we buy when the market is oversold, and we sell when the market is overbought.
Looking at the chart above, you can see that the stochastics has been showing overbought and oversold conditions respectively. Based upon this information, because the market was overbought for such a long period of time, we expect a price to go down soon.
That is the basics of stochastics. Many traders use stochastics in different ways, but the main purpose of the indicator is to show us where the market is overbought and oversold.