The myth is that Stochastics and RSI (Relative Strength Index) are both used to determine whether a market has reached overbought/oversold status, thus indicating when a trend is near an end or likely to reverse direction. However, RSI is more appropriate for gauging strength of trend. An RSI reading above 50 indicates bullish momentum and a reading below typically favors short positions. Meanwhile, a Stochastic is a more reliable indicator for identifying market turns, especially when partnered with divergence.

A Fast and Slow Combination

The Stochastic oscillator comprises the first line known as %K. The second line known as %D is a simple moving average of the %K. The most common setting for the Stochastic oscillator is 14 periods and a 3-period SMA (simple moving average) for %K, which is %D. In other words, %K is the faster moving Stochastic and %D is the slow one. Generally, the fast indicator is used for short-term trades, and the lagging turns in the slow Stochastic are more reliable for longer-term trades.

Stochastic Crossing Signals

Simple moving average crossings are possibly the most popular technical indicator for new traders. Seasoned traders tend to employ more complex indicators, such as %K crossing %D Stochastics. When %K crosses below %D a sell signal is generated. Conversely, a buy signal is produced when the fast gauge crosses above the slow one.

Overbought and Oversold Levels

The Stochastic Oscillator range fluctuates between 0 and 100 no matter how fast price ascends or descends. Traditionally, a reading above 80 is the overbought threshold and a reading below 20 is an indication of an oversold situation. A reading above 80 is not always a bearish signal nor is a reading below 20 bullish. In the AAPL chart below the stochastic was above 80 for about 3 weeks.

John Seguin, Market Taker Mentoring