The stochastic oscillator compares the current stock price to its price range over a specifically identified period of time. This indicator is based on the theory that in an upward trending market, stocks tend to close near their highs and in a downward trending market, stocks tend to close near their lows. That would indicate that as an upward trend erodes, stocks close further away from the highs and vice versa. The stochastic indicator attempts to reflect when prices start to group around their lows in an upward market, and just the opposite in a downtrending market. The theory is that these are the conditions that indicate a trend reversal is about to occur.

The stochastic indicator is plotted as two lines on a chart with values ranging from 0 to 100. They are the %D line and %K line and the %D line is considered the more significant of the two. Readings above the 80 line are strong and indicate that the price is probably closing near its high and likewise, readings below 20 indicate that price is closing near its low.

Ordinarily, the %K line will reverse direction before the %D line but, when the %D line changes direction prior to the %K line, a slow and steady reversal in the stock price is usually indicated. A very powerful move is indicated when the plot approaches 0 and 100. When the stochastic nears these extremes following a pullback in price, a good entry point is generally indicated. Many times, when the %K or %D lines begin to flatten out, this is an indication that the trend will reverse during the next trading range.

One of the simplest applications for the oscillator is to watch for the divergence on the chart. That is when the price is making higher highs but the stochastic oscillator is making lower lows, (or just the opposite). In either case, the indicator is usually demonstrating a change in price before price itself is reversing and this can help you determine when to enter or exit a position.