One of the most popular technical indicators are stochastic oscillator signals. Stochastics are widely used to determine reversals in price action for all financial markets. There are several key signals to identify within this study.

Stochastic signals are composed of two moving-average lines. Their movement is based on the rate of change in the market's closing price versus the high and low for a given time period.

The two moving lines are labeled %K and %D. The %K line is a faster moving average line while %D line is an averaged value of %K and therefore moves slower. Each is commonly referred to as the "fast" and "slow" lines, respectively.

There is a myriad of stochastic line settings and values to measure movement versus price action. We will defer such topics for now, while focusing on the underlying use of stochastic signals.

Stochastic signals consist of the %K and %D moving lines plotted within a fair-value zone of 0 to 100. When one or both lines approach or enter the 20% area on the graph, conditions are said to be oversold and a rally may be near. By the same token, price lines approaching or exceeding 80% are considered "overbought" and subsequent price declines are possible.

The best signals are when both lines exceed 20% (bullish) or 80% (bearish) zones and turn to reverse course. Lines turning away from these extreme zones, once violated, are strong signals of immediate price change.

Oscillator studies work best when giving buy signals on up trend pullbacks and sell signals on downtrend rallies. Taking only the signals that complement clear trends will eliminate many false readings.

Sideways or choppy markets without clear direction, up or Down, yield buy and sell signals with equal accuracy.

Stochastics also hint of nearby trend changes when comparing their movement to that of the underlying. Very predictable results are possible from this method of study.

Three different trading indications are commonly identified by stochastic movement; fast/slow line crossover, Type 1 and Type 2 Divergence. Let's take a look at each in the following charts below:

(daily chart, SUNW)

Sun Micro followed a defined uptrend in July. Conservative traders would ignore overbought signals to concentrate on oversold turns that offer new bullish entries to trade. We observe that hourly stochastics approached or entered the oversold zone and reversed three times, offering evidence of near-term price advances ahead.

Overbought "sell signals" near and above the 80% range too often gave false readings of price declines. Stochastics must be used together with non-oscillator tools to identify potential market trend changes.

(hourly chart, BRCM)

Broadcom traded without a clearly-defined trend over several Months, with wide price swings, as it formed a double-bottom head & shoulders formation. Note that there are nine clear instances where one or both stochastic lines approached or entered the overbought/oversold zones and reversed.

If we had taken trades based solely on this with no other filters, we would be profitable. Still, stochastics, like all other technical tools, are best used in harmony with and confirmation of other complementary studies.

(daily chart, Dow)

Our daily chart of the Dow shows a classic example of stochastic/ price divergence. Notice that in early April stochastic lines were deep in overbought territory and turned to reverse, while underlying prices continued to rise. This Type 1 divergence occurs when we follow price action and stochastics fail to follow suit. These are classic signs are nearby market reversals. (The small "tweezer-top" candle formation was a confirming technical signal as explained in the "Candlestick" study section)

(NASDAQ, hourly)

Can you see several clear signals for long or short positions as fast/slow lines approach or enter the 20% and 80% zones? Worthy of note in this chart is further Type 1 divergence where price action continues to make new recent highs, while stochastics fail to follow suit. This indicates that buying Exhaustion may be near, confirmed with stochastic lines plunging from overbought conditions, as prices tumble.

(hourly chart, SDLI)

Type two divergence occurs when we key on stochastic movement, but price action does not follow suit. In this example, SDLI stochastics registered lower-lows from the previous extreme while it's underlying made higher lows. This suggests price strength: the market is oversold to a greater degree in relation to last time at a point higher in price. This indicates prices should continue to rise from here.

As witnessed, stochastic technical studies are popular for a reason: They offer great insight to current and future price direction. Despite varied debate on optimum line-period settings and degrees of crossover, the basis of this study remain the same. Divergence between current price action and stochastic line direction can clearly signal near-term price direction.