There are three main ways to interpret the stochastic oscillator in technical analysis. The most widely used technique is to consider the underlying security over-bought whenever either line moves above 80 on the graph. The security would also be considered over-sold whenever one of the lines falls below 20. This idea is very simple and I am sure you can see many tops and bottoms which are also
stochastic tops and bottoms on any graph.
The second method used to interpret this indicator is to compare the tops and bottoms of the indicator compared to the same peaks and valleys of the prices of your underlying security. Quite often you can see a divergence being set up as higher highs or lower lows are showing up in the security prices while the oscillator will be making lower highs or higher lows.
Look at a graph of the DJIA between August and Oct, 1999. On August 17, you can see a small peak in prices and a peak in the stochastic oscillator as well. Seven days later, on August 24, you see the DJIA makes a higher high, while the stochastic oscillator makes a lower peak.
This type of action is evidence of a classic divergence being set up and is something you should look for whenever you use oscillators. This type of chart formation should lead you to believe the current trend of higher highs and higher lows in the security price may be coming to an end shortly. It could also possibly signify a change in the primary direction or trend of the security price.
In actuality you can see the follow through to the downside which occurred. During the charted period of time from the "2" until the end of the chart, the DJIA lost over 1300 points in a matter of only 7 1/2 weeks.
The third interpretation of the oscillator is comparing the %K and %D to each other. You would consider it a buy signal whenever %K rises above %D and a sell signal whenever %K crosses and moves below %D.
In most computer programs %K is a solid line and %D is a dashed or dotted line. In the chart above %K is the red line while %D is the black line. Using the crossing method to buy or sell the DJIA in the URL chart above would have caused some whip sawing but quite a few large profits as well.
When using the stochastic oscillator within a limited time frame, it is difficult to trade the third interpretation mentioned above because of the possibility of many whip-saws. It does have it's limitations and is NOT for every market condition.
When setting up your stochastic oscillator, you can vary the time periods used by the program. %K is the number of time periods used in the stochastic calculation and you may set it to any number you desire. MetaStock for Windows defaults to 5 with a slowing value of 3. The slowing value controls the smoothing of %K. 1 is considered fast while 3 is said to be a slow stochastic.
The %D periods is also a variable you may wish to test. It is the number used to calculate the moving average of %K which is usually drawn as a dotted line on your computer chart. MetaStock defaults this value as 3.
While the standard defaults of your program will quite often be fine for your analysis in most situations, you should test them and look at the oscillator using other variations. You may discover a setting which more accurately reflects your tradingstyle and time period relevancy.
The stochastic oscillator is a great indicator to use in your analysis, but you must understand that it works best in a trading market or security. It can potentially lead you astray of your objectives in a trending market or security. Stocks and markets can and will get over-bought or over-sold and stay
that way for extended periods of time.
The stochastic oscillator should be considered as only one of many tools to help in your analysis and NOT the holy grail. Use it with all your methods and indicators and it may help you improve your timing and trading.