Oversold? Overbought? Although stochastics don't clearly define a trend, they provide a way to view short term technical conditions of a trend. Stochastics are usually more descriptive than predictive, though there are instances in which they can give a good signal. The usefulness of stochastics depend upon one's trading style, the shorter the time span you are interested in, the more useful they can be. Our focus is the 3-6 month range. So we use 1, 3 and 12 month stochastic charts.

What can be determined about the next point from the stochastics chart above? The next point looks as though it will be similar to the last close. Why? Look at the last day of the above stochastics chart, August 9, 2002. The fast red line and the slow blue line are widely divergent and moving upward. The two lines are not likely to cross or converge on the next trading day. To do that the market would have to forget the upward trend line on open the following Monday morning and gap down below the moving averages and/ or close the day in such a manner. The weightier information from all the other indicators, for example, the VIX activity, the Bollinger band violation, the trend lines, etc., indicates that it isn't in the cards. For similar reasons, it can be assumed that there would be a more or less orderly rise from a golden cross of the moving averages in the coming days. Estimating support and resistance from recent peaks and troughs in the price and moving average chart gives an indication that there is good support at about 900 and resistance at about 925 or so.

The two charts above are for Monday, August 12 and Tuesday, August 13, 2002. Monday opened at the same level as the previous Friday close and closed above 900. The two stochastic lines did not cross or converge on the next trading day. Tuesday opened above 900 and then lost ground to close at 884 providing a third point in the trend line. This close was low enough to make the fast stochastic line cross over the slow line. The most important point on any chart is always, the next point. There was a crossover. So for the next point, the close on the following Wednesday, August 14, would you expect that this crossover would indicate a close below 884 on the following day? Maybe if you looked at stochastics without considering other things. In this instance there is a strong upward trend. Stochastics do not work well during a trend.

The chart for Wednesday, August 14, shows that the close on Tuesday was a test of the trend line. After the open at 884 the SPX made a healthy gain of 35 points to close at 919. On Thursday, August 15, the SPX closed at 930, completing a whipsaw of the stochastics and keeping the indicator well into the overbought area just above the 80 line. There are two ways the stochastics could ease back to a level which is either not oversold or is less oversold. One way would be for the price of the SPX to decline. But that is not likely to happen in a strong uptrend. The second way would be to let the moving averages catch up to the stochastics. In the second case, the SPX price could either continue to hug the Bollinger band upward or tread water remaining in a range. Both of these alternatives would allow the moving averages to catch up to the stochastics.

On August 16, 2002, we wrote: "Where will the market go next week, August 19-23? We checked the charts from Bigcharts.com We would guess that the SPX would consolidate during the week and end up. The SPX may continue to hug the upper Bollinger band upward" Then we wrote, "Stochastics are unremarkable."
Ham-Jam asked why we had said that the stochastics were unremarkable. Here is the price chart with stochastics for the the SPX for Friday, August 16, and for the following Monday, August 19, 2002.

As you can see the stochastics are unremarkable. They don't seem to indicate much of anything except that the SPX is overbought. The overbought condition is relative to the moving averages, not the intrinsic value. What about the crossover points? What about them. The changes they may seem to signal can change right back again. Look at the way the fast and slow lines have twisted around each other in the charts for 8/20 and 8/22.

What specifically does the stochastics chart represent or measure? Overbought or oversold conditions. Conditions in which the price is above or below the moving averages. You can see such conditions on the price chart, but the stochastics make them much more visibly apparent. When is it most useful? Short term or when conditions are range bound. When is it least useful? Long term and for strongly trending conditions.

A couple of caveats.
During trends stochastics can show overbought or oversold conditions which remain overbought or oversold for a relatively extended period. Stochastics are dependant upon the moving average. Therefore, sometimes when the market, index, or security is highly overbought or oversold, if the price remains in a certain range for a period of time, the stochastics can retreat from being overbought or oversold. Also due to the dependance upon moving averages, recent conditions have most significance whereas previous conditions have diminishing significance. Recent and previous states can not be directly compared to each other. Another caveat for stochastics is that the same price can be represented in two places on the same chart as being both oversold and overbought. That is again because stochastics are not dependant upon intrinsic value, but rather upon moving averages. In the SPX chart below, two price areas have been highlighted. The earlier one is at about 975 with a P/E value of about 40. The later highlighted price area is at about 940 with a P/E value of about 38. The stochastics show the former to be highly oversold, whereas stochastics show the latter lower price area to be overbought.

How is the stochastics oscillator calculated?
"In the way that we are using it here, stochastics refers to its range over a set period of time. The time span most often used is 14 days. The stochastics oscillator determines where the current price is located on a percentage scale from 0 to 100, in relation to its price range over the past fourteen days. The formula for stochastics is quite simple:

where Close represents the latest closing price and high and low are the respective highest and lowest values for the past 14 days. The slower %D line is a 5-day moving average of the %K line."
The Visual Investor, Murphy, p. 110.

""This type of oscillator is most useful during choppy market periods and when a trend is nearing completion. They are much less valuable in a strong trend. Therefore, oscillators should not be overused and should be deemphasized during strong trending markets. For example a moving average is more helpful during a strong trend."
The Visual Investor, Murphy, p. 110.

Other overbought/ oversold indicators you may already know:
RSI, Relative Strength Indicator

MACD, Moving Average Convergence Divergence indicator

DMI/ADX, Directional Movement Indicator and its Average Directional Movement line.