there are 3 different types of stochastic oscillators: the fast, slow, and full stochastic. All of them operate in a similar manner however when most traders refer to trading using the stochastic indicator they are referring to the slow stochastic which is going to be the focus of this lesson.
The basic premise of the stochastic is that prices tend to close in the upper end of their trading range when the financial instrument you are analyzing is in an uptrend and in the lower end of their trading range when the financial instrument that you are analyzing is in a downtrend. When prices close in the upper end of their range in an uptrend this is a sign that the momentum of the trend is strong and vice versa for a downtrend.
The Stochastic Oscillator contains two lines which are plotted below the price chart and are known as the %K and %D lines. Like the RSI, the Stochastic is a banded oscillator so the %K and %D lines fluctuate between zero and 100, and has lines plotted at 20 and 80 which represent the high and low ends of the range.
Example of a Stochastic Oscillator
Whatever charting package you use will calculate the lines for you automatically but you should know that the data points which form the %K line are basically a representation of where the market has closed for each period in relation to the trading range for the 14 periods used in the indicator. In simple terms it is a measure of momentum in the market.
The %D line is very simply a 5 period simple moving average of the %K line. Lastly you should know that you can change the inputs for the indicator and use for example a 3 period moving average of the %K line to get faster signals, however as this is an introduction to the indicator and because most traders I know do not change the standard inputs, I do not recommend changing them at this point.
Like the RSI the first way that traders use the stochastic oscillator is to identify overbought and oversold levels in the market. When the lines that make up the indicator are above 80 this represents a market that is potentially overbought and when they are below 20 this represents a market that is potentially oversold. The developer of the indicator George Lane recommended waiting for the %K line to trade back below or above the 80 or 20 line as this gives a better signal that the momentum in the market is reversing.
Example of Overbought and Oversold Signals
The second way that traders use this indicator to generate signals is by watching for a crossover of the %K line and the %D line. When the faster %K line crosses the slower %D line this is a sign that the market may be heading up and when the %K line crosses below the %D line this is a sign that the market may be heading down. As with the RSI however this strategy results in many false signals so most traders will use this strategy only in conjunction with others for confirmation.
The third way that traders will use this indicator is to watch for divergences where the Stochastic trends in the opposite direction of price. As with the RSI this is an indication that the momentum in the market is waning and a reversal may be in the making. For further confirmation many traders will wait for the cross below the 80 or above the 20 line before entering a trade on divergence.
This is the most popular indicator that mom&pop traders are using. Perhaps, MACD is the second most.