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Here, first-time STOCKS & COMMODITIES contributor David Lundgren reminds us that the stochastics indicator is just a guide to understanding the trend for trading.

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Stochastics, or any technical indicator for that matter, is just a mathematical formula that processes data from one form into another. That's all it is. It is not the crystal ball that you have been in search of all your life. It is simply a guide (and a very effective one at that) used to either confirm or contradict other analyses of the most important data of all — price action.

Before you consider a technical indicator, first you must do your homework on price action, which means studying hourly, daily, weekly and monthly bar charts of the market in question. This must then be supplemented by studying intermarket relationships that affect the market that you are trading. Only after you have established a directional bias for this market should you incorporate stochastics and other technical indicators into your analysis, looking for signals that either confirm or contradict your expected price trends.

If your price analysis is confirmed by stochastics, then you can trade with more confidence in your outlook. But if the stochastics indicator contradicts your conclusions, then you should either stay on the sidelines and wait for the stochastics indicator to agree with you or simply trade in the direction of trend analysis, but with less exposure than you would otherwise take on. Never trade against your trend analysis just because stochastics contradict what you are observing.

STOCHASTICS FORMULA

First, stochastics indicators are designed to inform you when an advance or a decline has become overbought or oversold. The formula for stochastics is as follows:

%K={Current close - Lowest Lown / Highest Highn - Lowest Lown}

The n period is the number of lookback days selected by the user.

%D is a smoothed version of %K and is used as a crossover method to indicate trend.

Intuitively, what this formula attempts to measure is where today's close is relative to the highest high and the lowest low recorded over the past n days. If %K equals 100, then price is trading at the highest level in n days. If %K equals zero, then price is at its lowest level in n days. Because it is obvious that the close must be above the lowest low and below the highest high, the stochastics reading will always fall between zero and 100. Because each individual close can be quite random, the pure stochastic number can be very volatile. Typically, this volatility is smoothed out by smoothing %K with the above formula, resulting in %D; this version is called fast stochastics. There is an additional version where %D is relabeled %K and is smoothed with a three-period simple moving average, which is called slow stochastics.

STOCHASTIC: THREE WARNINGS

Typically, stochastics give at least two warnings (sometimes three) that a trend is nearing an end. The first warning comes when stochastics reach an overbought reading (a %D reading above 80) or an oversold reading (a %D reading below 20). Of the three warnings, this is the least important. An overbought reading, for instance, can last for years before a meaningful correction unfolds. An example can be seen in Figure 1. Here, we see that overbought readings existed on stochastics during three very powerful advances in the Eurodollar — 1984 to 1987; 1988 to 1989; and 1991 to late 1992. Anyone who ignored price action and attempted to sell Euros short did so at their own financial peril. Once an extreme reading is registered, traders should be more concerned with the direction in which the stochastics are headed than whether they are  overbought or oversold.

The second warning comes when %K either crosses down over %D from an overbought level or crosses up through %D from an oversold level. This warning is more important than a simple extreme stochastic reading, because it suggests that the trend is tiring. At this point, partial profits should be taken, and trades contrary to this crossover signal should be avoided. However, this signal does not mean that the trend is over. Once again looking at Figure 1, we see that several crossovers occurred in overbought territory, but the trend continued upward nonetheless. At this point your technical analysis of price action becomes crucial. Is a reversal or topping chart pattern forming? Is volume heavy on price weakness? Are related markets confirming the weakness seen in the market you are trading? If the answer is "no" to any of these questions, chances are that the is trend is not over yet.