Stochastics Histogram

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On a chart, Stochastics is represented by two lines: %K (blue line) and %D (red line), where %K is fast or slow Stochastics and %D is the moving average applied to %K. It is common to refer to the %K line as Stochastics and the %D line as the Signals line.

There are several ways of using Stochastics in technical analysis. By its nature, Stochastics represents how far from the most recent low and most resent high the current price of a stock (other tradable security) moves. Thus, when Stochastics moves above 80, it is considered that an analyzed security is moving close to its most recent high level and tends to be overbought. When Stochastics drops below 80 after being above that level, it reveals that the security price is moving away from its recent high level (moving down) and such an event could be considered to be a confirmation of a trend reversal and could be used to generate a "Sell" signal. Also, when Stochastics crosses 20 after being below it, it tells us that the price has started to move up from its most recent low level. This could be considered to be a "Buy" signal. A trader may select different Stochastics' levels to generate Buy/Sell Signals. Still 20 and 80 are the most popular.

Another way to generate "Buy/Sell" signals is to follow crossovers of the Stochastics Line (%K) and its Signal Line (%D). In technical analysis, a Stochastics below its Signal Line indicates a bearish trend (down-trend) and a Stochastics above its Signal Line indicates a Bullish trend (up-trend). Therefore, when the Stochastics declines and crosses its Signal Line, it can be considered to be a "Sell" signal and when Stochastics crosses its Signal Line on its move upward. this can be considered to be a "Buy" Signal. This method of generating trading signals serves to reduce the lag that exists in the first method described above.

One of the simplest ways to define Stochastics and its Signal Line crossovers is to build a Histogram. That is, calculate the difference between Stochastics and it Signal Line:

Stochastics Histogram = Stochastics(%K) - Signal Line(%D)

From the formula above, the points where the histogram crosses the center line (zero line) are equivalent to the crossovers of Stochastics and its Signal Line and can be used to generate Buy/Sell signals.

Chart 1:S&P 500 Index (^SPX) - Stochastics and Double Stochastics

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