The Stochastic Oscillator has been around since the late 1950s and was created by George C. Lane and is a momentum indicator. The stochastic oscillator uses three values in its calculation, the days High, Low and Close price. If the days close is closer to the periods high over the set period then the stock is going to show that there is buying pressure, and it will show that there is selling pressure if the days close is closer to the periods low over the set period.

The Stochastic Oscillator consists of two lines, the %K and the %D, the %K point is plotted by using the following calculation
%K = 100 * ((Recent Close - Lowest Low) / (Highest High - Lowest Low))
Highest High = the highest point the price reached over the set period of days.
Lowest Low = the lowest point the price reached over the set period of days.
The %D point is plotted by taking the 3-period moving average of %K. The most common period used by technicians is a 14-day period. The %K line is a percentage so it will always fluctuate between 0 and 100, where any value over 80 generally shows that the stock is overbought, and any value under 20 generally shows that the stock is oversold. The %D line acts a trigger line for the %K line, this means that whenever there is a crossover between the two lines, it is possible that a change in direction or change in momentum of the stock is happening.

When the %K line goes over the 80 or 20 points, it doesn't always mean that the stock is going to change directions, but what you should look for is the point that the %K line crosses back over from above or below the 80 or 20 point, respectively. this is the point that shows yes, the price has become oversold, but the market has started to buy it again to bring it back up, (or vise versa for overbought). Working solely on overbought, oversold and crossovers will usually give you a fair amount of 'whipsaws' or false signals. probably the most reliable indicator is to look for divergence between the price direction and the stochastic direction, followed by a crossover of the 80 or 20 line. Let em explain Divergence a little better, in an overbought case, you want to see the price making new highs, while the Stochastic is making new lows, (or highs points that are less then the previous high point).

There are three different types of common Stochastic Oscillators, Fast, Slow and Full. So far what we have discussed is the Fast Stochastic. With the fast stochastic you are going to see a lot of crossovers between the %K and %D lines. The slow stochastic tries to minimize the crossovers by making the %K line a 3-day SMA of the Fast stochastic's %K line. Then the %D line becomes the 3-day moving average of the new %K. This means that the slow stochastic's %K line is the same as the fast stochastic's %D line. By doing this, the lines get averaged out, and are a lot smoother and generate a lot fewer crossovers. Personally I use the slow stochastic in all of my charts. The final type is the full stochastic, what this does is take it one step further and allows you to specify the number of periods to smooth out both %K and %D lines. The Full stochastic and Slow stochastic take two parameters, (14, 3) where 14 is the number of days in the period and 3 is the number of days in the moving average of the %D line. The full stochastic takes 3 parameters, (14, 3, 3), where the first and last parameters are the same as before, but hte middle one indicates how many days to use on the %K moving average. in this case, we would have a period of 14 days, the %K line would be a 3-day SMA of this, and the %D line would be a 3-day moving average of the %K line. Look familiar? it should, because we just duplicated the slow stochastic with the full stochastic.

Used by itself the stochastic oscillator is a good indicator to use, but when used in conjunction with other indicators it can become very powerful and the cornerstone of your technical toolbox. I personally look first to the stochastic indicator for a buy signal, then I will verify it with the other indicators I use. If they all line up, then I am very confident that I will have a winning trade. Hopefully the stochastic oscillator will be as good to you as it has been for me.

Disclaimer: Technical Analysis is speculative by nature and cannot be relied on as a 'sure thing'. Always do your own research and seek professional advice before initiating any trades. I am not a professional and my writing should not be taken as advice. I do not give any guarantee of success or failure through the use of this technical indicator.