Invented by George Lane in the 1970s, stochastic indicators discern the relationship between the closing price and the high and low of a bar. Lane observed that as prices increase in an upward trend, closing prices tend to be closer to the upper end of bars.  In a downward trend, closing prices tend to be closer to the lower end of bars.

The stochastic oscillator is also a momentum based indicator which relies primarily on support and resistance lines.  By comparing closing price to the range of prices the security has traded within, the stochastic oscillator will help determine reversals in price.   If the price of a security has been closing regularly at or near the top of the oscillator range, generally accumulation is occurring and conversely if the closing price is at or near the bottom of the range, a selling pattern is present.

Use the Stochastic Oscillator to determine both momentum and whether a stock is overbought or oversold.  The Stochastic Oscillator will assist a trader during trending and stagnate markets. Remember, enter a long position if the Stochastic line is above the signal line, and enter a short position if the stochastic line is below the signal line.  Additional stochastic information confirms buy and sell signals when a crossover occurs above or below predefined levels.

When trading, any reading below 20 is considered oversold and any reading above 80 is considered overbought.  Buy and sell signals appear when %K crosses above or below %D. However, these signals are not always dependable, and a trader should be aware of this as the crossover signal occurs frequently.

If the oscillator rises above the overbought line, wait for a downward trend to take the oscillator below 80. If the oscillator crosses below 80 and returns above it, disregard this signal. If it dips below 80 for a second time, be prepared to sell a long position.  These same techniques can be used to identify a buy signal at the oversold level when the oscillator moves from below to above 20.  On the second advance, be prepared to buy the stock long.