This technical analysis tool was created by George Lane in the 1950's. You can use it to see the relationship between the closing price and the price range (high and low) over a certain number of periods.
It's creator says this about it: "It doesn't follow price, it doesn't follow volume or anything like that. It follows the speed or the momentum of price. As a rule, the momentum changes direction before price."
The Stochastic Oscillator is a momentum indicator and consists of two lines on a chart:
The %K Line, that uses the most recent close, the highest high over the last 14 periods and the lowest low over the last 14 periods to calculate it's value.
The %D Line, that uses a 3-day Simple Moving Average of %K and acts as a signal line when crossing with the %K Line.
Interpreting the Stochastic Oscillator
A strong buying signal is given when both lines have first been below 20% and then close above 20%.
Buy when the %K line closes above the %D line.
A strong sell signal is given when the two moving averages that comprise it have first been above 80% and then close below the 80% level.
A sell signal is given when the %K line closes below the %D line.
What to look for is when prices are making a series of new highs and the lines are failing to surpass their previous highs.
There are two types of Stochastics and the only difference is an extra moving average. The first one is the more irratic moving indicator on the chart.
This is the smoother of the two. The one that the creator of this indicator preferred, because it emphasizes the buying signal he would look at.
%K = (Current Close - Lowest Low)/(Highest High - Lowest Low) * 100
%D = 3-day SMA of %K
Lowest Low = lowest low for the look-back period
Highest High = highest high for the look-back period
%K is multiplied by 100 to move the decimal point two places