Stochastic processes are those that change in a seemingly random way. This applies to many activities of human endeavor including science, technology, and finance. In finance, in particular, this refers to the attempt to make sense of the apparently random association between series of price data.
The technical indicator known as the Stochastic Process was created by an investment educator named Dr. George Lane in the early 1980s. Lane had discovered a correlation between turns in market action and the phenomenon of closing prices closing at the extremes of market highs and lows. In other words, during a bullish uptrend move, the closing prices tended to group at the top of the market range for each price period rather than at the center or bottom of that range. The corollary is true of prices in a falling market, where closing prices were grouped at the lows of the period range.
The Stochastic Process, or, to use its more commonly-used term, “stochastics” is an oscillator indicator, which means that its optimal usage is best seen in markets that are trending sideways, in a range. As such, it is excellent at spotting points in such a trading range where a short-term change of trend is about to take place.
The indicator itself comprises two lines known as %K and %D. These are often shortened to the “K-line” and the “D-line”, or simply K and D. The
K-line represents the actual stochastic measurement, which defines the percentage basis from 0 to 100, where the closing price of a commodity resides relative to the total range for a selected number of time segments, with a 5-period range being the most commonly used. The D-line is a smoothed moving average version of the K line. When you look at a stochastics chart, K is the solid line, while D is the dashed line that trails slightly behind it.
As with the majority of oscillator indicators, the correct way to use stochastics is to look for divergences between the indicator and the underlying price action at extreme levels of the indicator’s range. As with the Relative Strength Index (RSI), those levels are below 15 and above 85. If the stochastics and price indicator diverge within those ranges, then that is a good indication of a change in trend, with the best signals given in the direction of the prevailing trend. For example, if the price action is currently sitting at the bottom of a defined sideways price range, and the suggestion is that prices will again rise to the top of that range, then a buying stochastics indicator is likely to be more accurate than a selling indicator. It always takes a much stronger indicator signal to suggest a reverse of a trend.
Note that stochastics can provide many false signals, which is why it is important only to trade on the K/D crossovers at the optimal point, where divergences appear at the extreme levels of the indicator.
There is also a more smoothed version of the classic stochastics indicator known as “slow stochastics”, where the indicators are called SK (slow K) and SD (slow D). This version smooths out some of the whiplash moves and is normally the indicator of choice for most professional traders.