In the 1990s Dr. George Lane undertook a detailed investigation into technical analysis, and tried out many different and new indicators and oscillators. The Stochastic Oscillator was one of them, and for a while it was considered the best oscillator you could use.
It is different from many other indicators in that it looks in more depth at the distribution of the price within each daily bar – most oscillators just use the closing prices. The principle of the Stochastic is that it looks at the relationship of the closing price to the range of prices that have been seen in the past few days. When an uptrend is strong, the closing price will tend to be near the top of the range, and this is reflected in the Stochastic Oscillator.
There are two types of Stochastic Oscillator, and two components to each of them. The first component has the unusual name of %K, and this is the basic calculated indicator. It's called %K because, as explained above, Dr. Lane was experimenting with many different indicators, and he labelled them alphabetically. The one that worked just happened to be the 11th he tried. It's usually normalized to a percentage, and as with many oscillators, it can be used to indicate oversold conditions, at 20% to 30%, or overbought conditions, at 70% to 80%.
The Stochastic Oscillator has another line, which is used as a signal, and this is called the %D. It's a smoothed version of %K, using a three day moving average. Those are the two components of what's called the Fast Stochastic. The other type of Stochastic Oscillator is called the Slow Stochastic, and that starts with the %D line, using that as the first indicator line and calling it %K. The slow %D is again another smoothed line.
It's a matter of personal preference which Stochastic you use. The Fast Stochastic will give you earlier signals than the Slow, but they are not so reliable.
Strategies for using the Stochastic can be similar to other oscillators. For instance, you may take a long position when the %K rises up through the 20% level, signifying that the market is recovering from being oversold. The equivalent of this for taking a short position is the %K passing down through 80%.
However, the %D is called a signal line, and is often used as the signal for action when it crosses the %K. The rule for this is that when both lines are below 20%, and the %K crosses from below to above the %D, that is a signal to buy. As always, this should be confirmed by another indication and not traded on by itself. If both lines are above the 80%, and the %K line drops to below the %D, this can be taken as a signal for a short position to be taken.