The stochastic indicator can help determine when a market is overbought or oversold.
The stochastic indicator is:
The original stochastic oscillator, developed by Dr. George Lane, is plotted as two lines called %K, a fast line and %D, a slow line.
Although this sounds complex, it is similar to the plotting of moving averages. Think of %K as a fast moving average and %D as a slow moving average. The lines are plotted on a 1 to 100-scale. "Trigger" lines are normally drawn on stochastics charts at the 80% and 20% levels. A signal is generated when these lines are crossed. The zones above and below these two lines can be referred to as the stochastic bands.
The original stochastic is sometimes referred to as the "fast" stochastic to differentiate it from the "slow" stochastic. Some traders feel the fast stochastic %K line is too sensitive and, to improve their analysis, they replace the original %D line with a new slow %K line. The new slow %D line formula is then calculated from the new %K line. The result is a pair of smoothed oscillators that some traders believe provide more accurate signals.
The 80% value is used as an overbought warning signal, and the 20% is used as an oversold warning signal. The signals are most reliable if you wait until the %K and %D lines turn upward below 5% before buying, and the lines turn downward above 95% before selling.
An overbought or oversold level indicates that a market may be vulnerable to a retracement
The Stochastic Oscillator generates signals in three main ways: