'Stochastic Oscillator' is a momentum indicator developed by George C. Lane in late 1950s.It uses the support and resistance levels. Stochastic compares the security's current closing price to its price range over a specific time period. But it does not blindly follow price, volume. Instead it is purely based on the speed or momentum of price.

Stochastic Oscillator is used to identify the bullish bearish trend and a possible future reversal. It also indicates the over sold and over bought levels.

The Stochastic Oscillator can be defined as

%K = 100 * (Current close price - Lowest price of the period) / (Highest price of the period - Lowest price of the period)

%D = 3-period Simple moving average of %K

There are three types of Stochastic Oscillator. Fast stochastic oscillator, Slow stochastic oscillator and the Full stochastic oscillator. Among them the fast stochastics is the original stochastic oscillator based on the above said formula of Dr. George Lane. The fast stochastics is very choppy and more sensitive (too responsive to price changes) compared to slow stochastic. This will result in the premature unwinding of positions. So some traders prefer slow stochastics than fast stochastics.

The slow stochastics uses three-period simple moving average smoothed fast stochastic's %K instead of '%K basic calulation' of the fast stochastics.

After the first simple moving average is applied to the fast stochastic's %K, another three-period moving average is applied to get the slow stochastic's %D.

The formula is

Slow %K = Fast %K smoothed with 3-period Moving average

Slow %D = 3-period Moving average of slow %K

Using slow stochastics reduces the chances of false crossovers and thus prevents false unwinding of positions.

The full stochastics is more advanced type of stochastic oscillator. It is the generalization of fast stochastic oscillator and the slow stochastic oscillator.

The formula is,

Full %K = N1 Period simple moving average of the fast %K

Full %D = N2 period Simple moving average of Full %K

Here N1 is the number of periods used to calculate the fast %K and N2 is the number of periods by which the full %K line is smoothed.

Unlike the The fast stochastic oscillator and the slow stochastic oscillator, the full Stochastic oscillator has three parameters.The first one is the look back period, second one is the number of periods for slow %K and the third one is the number of periods for %D moving average. In a full stochastic oscillator with parameters 14,3,3 , (14,3) is the fast stochastic oscillator parameters and (14,3) is the slow stochastic oscillator parameters.

There are three different ways to trade using stochastic oscillators.

1. Crossover method-

The first one is based on the crossing of %K and %D signals. When stoch %K crosses above stoch %D 'buy' signal occurs. When %K line crosses below %D line 'sell' signal occurs.

The second one is based on the 50 level cross over. When %K line crosses above 50 a 'buy' signal occurs and when %K line crosses below 50 a 'sell' signal occurs.

2. Divergence in Stochastics and Price method-

In this method traders uses the divergence between price and stochastic oscillator. When lower lows in price and higher lows in stochastic oscillator is formed it is called bullish divergence and here a 'buy' signal occurs. When higher highs in price and lower highs in stochastic oscillator is formed it is called bearish divergence and here 'sell' signal occurs.

3. Over sold and Over bought levels method-

If the stochastic oscillator is higher than or equal to 70% level it is called over bought. To confirm the condition wait till it crosses 80% level. After crossing 80% level if it moves back to 70 level a 'sell' signal occurs. When the stochastic oscillator is lower than or equal to 30% level it is called over sold. To confirm Wait till it crosses 20% level. After crossing 20% level if it moves above to 30% level a 'buy' signal occurs.