A technical indicator that oscillates and reflects the momentum of the market.
Overview
The Stochastic Oscillator was developed by by George C. Lane in the 1950′s. It is a momentum indicator designed to show the relation of the current close price relative to the high/low range over a specified number of periods using a scale of 0-100. The theory is that in a rising market the price(s) will close near the high of the range and in a declining market the price(s) will close near the low of the range.
When plotted on a chart, the indicator is usually plotted as 2 lines: %K and %D. %K is the main (fast) line and %D is the signal (slow) line.
The formula for a component of the full stochastic, otherwise known as the Fast Stochastic is as follows:
Fast %K = ((Today’s Close – Lowest Low in %K Periods) / (Highest High in %K Periods – Lowest Low in %K Periods)) * 100
%D = 3-period simple moving average of Fast %K
The Stochastic Oscillator is calculated by the formula:
Fast %K = ((Today’s Close – Lowest Low in %K Periods) / (Highest High in %K Periods – Lowest Low in %K Periods)) * 100
Slowing %K = N-period moving average of Fast %K
%D = N-period simple moving average of Slowing %K
The Fast Stochastic and the Full Stochastic Oscillators on the EUR/CAD Daily Chart on 3/30/2011. Note that the full stochastic formula “smooths” out the fast one. Also note that the market declined when the stochastic crossed back from above 80% on the right side. However, on the left side, we saw the market continued lower despite the Stochastic Oscillator showing oversold condition, and even a bullish divergence. 
Source: VT Trader
Interpretation
The Stochastic Oscillators provides three basic signals.
Crossovers: 1) %K line / %D line Crossover: The %K line crossing above the %D line provides a buy signal, the %K line crossing below the %D line provides a sell signal. 2) %K line / 50-level Crossover: A buy signal occurs when the %K line crosses above 50 and a sell signal occurs when the %K line crosses below 50.
Overbought/Oversold Conditions: The market is considered overbought when the indicator is above the 80% level. Alternatively, the market is oversold if the indicator is below the 20% level.
Divergence: Higher prices highs accompanied with lower indicator highs is a bearish divergence and suggests bearish reversal. Lower prices accompanied with higher indicator highs is a bullish divergence and suggests bullish reversal.
Note that a trending market can remain overbought, or oversold, even in the presence of bearish or bullish divergences and like any technical indicator should be combined with other methods of analysis to make trading decisions.
