The Stochastic oscillator is a momentum indicator developed by George Lane, which tries to capture the inherent change in the momentum. Lane believed that the momentum would change direction much before the actual price. This oscillator indicates the position of the final closing price of the day relative to the high and low of the day over a period of time, revealing the state of the momentum. A series of closes near the day high would take the indicator over the 80% level, the overbought zone and for closes near the day low, below 20% or the oversold area. The indicator tries to find out the state in which the closing price develops closer to the day lows rather than the day highs, hinting towards a possible reversal.
Advantages & Limitations of Stochastic
Between the two lines, designated as the %K and %D, the more important line is %D, the slower one. When %D goes above 80% or below 20%, followed by a turn to the opposite side, a change in trend can be expected. Any divergence between the price and the indicator works well too. On the other hand, a very strong trending move can keep both the lines above the 70-80% or below 20-30% levels for a prolonged period of time, generating multiple false signals.