How To Use Stochastics To Determine Overbought Oversold Levels

The stochastics indicator is one of the simplest, most useful and widely used technical indicator out there. If you use it, your investing or trading accuracy will improve dramatically. You will also know when to sell a stock before it collapses and when to start accumulating a stock before it rises. 

The stochastics indicator is an oscillator. It will oscillate between two points (0-100) which are shown on the chart as overbought or oversold.

  • A reading of over 80 is overbought
  • A reading of below 20 is oversold

Stocks tend to rally when they are oversold. They also tend to decline when they are overbought.

I use the stochastics indicator 14 %K 3 % D 3. There are many settings but I prefer to use the original settings on my Freestockcharts.com charting software.

Take a look at the chart above with the stochastics indicator.

  • The red line is the oversold area
  • The green line is the overbought area

Notice how around November to January the stock rose when it reach an oversold level and it declined when it reach an overbought level.

You might notice that from August to October, the stock continue to rise even if it was overbought. That's because the indicator does not work all the time. There's an explanation for this but experience will tell you why.

The Rules Of Interpretation 

When I was in law school, my lecturer always told me this: For every general rule there is always exceptions. It is no different when it comes to technical analysis.

The general rule for stochastics is this:

  • When the stochastics goes above 80, the stock is considered overbought
  • When the stochastics goes below 20, the stock is considered oversold

The exceptions are this:

  • When a stock is in an uptrend, the stochastics can be overbought for a long time without the stock declining
  • When a stock is in a downtrend, the stochastics can be oversold for a long time without ever rising

Therefore, when a stock is in an uptrend, you can generally ignore an overbought reading but you should definitely take note when the stock gets oversold. On the flip side, when a stock is in a downtrend, you can generally ignore the oversold reading but you should take note when the stock gets overbought.

The 3 Different Trends Of The Stock Market

In the chart above, you can see how Square had an uptrend from November onwards. While it was in an uptrend, the stock entered an overbought level for a very long time without the stock declining. That is why you can safely ignore overbought levels when a stock is in an uptrend.

When the stock had a correction in January and gets oversold, it gave traders a very good swing trading opportunity to buy the stock and hold it for a few days.

In the chart above, you can see how DRYS was in a downtrend. It remained at an oversold level for a very long time without bouncing up until mid November. Once it had a bear rally, the stock entered into overbought territory and this gave traders a very nice shorting opportunity.

Stochastics Are Great For Non Trending Stocks

While the stochastics indicator is not very reliable at times for stocks that are trending in Stage 2 or Stage 4 (The 4 Stock Market Stages Every Stock Will Go Through), they are excellent for stocks that are trading sideways.

In the chart above, you can see how INCY was trading sideways and slowly drifting higher. Notice how the stochastics indicator pointed out reversal areas quite accurately.

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