The stochastic oscillator is a popular momentum indicator. It compares the price range over a given time period to the closing price over the period. It is highly sensitive to price movements in the market and perhaps oscillates more frequently up and down than nearly any other momentum indicator.
This sensitivity to price movement can provide early signals of directional change in a market, but it can also provide a lot of false signals. The stochastic's sensitivity can be reduced by altering the time period used or by using a moving average of the stochastic oscillator’s value.
The basic theory behind the stochastic oscillator is that prices generally close near the high in an up-trending market, while in a down-trending market prices typically close near the low. Trading signals are given when the %K line crosses over a three-period moving average line known as the %D.
Some of the best technical indicators to complement the stochastic oscillator are moving average crossovers and other momentum oscillators.
Moving average crossovers can be used as a complement to crossover trading signals given by the stochastic oscillator. A bullish crossover, which occurs when a short-term moving average crosses from below to above a long-term moving average, confirms an upward trend. A bearish crossover provides additional confirmation of a downtrend indication.
Other momentum indicators such as the relative strength index (RSI) or the moving average convergence divergence (MACD) can also be used to complement the stochastic oscillator. Either of these commonly-used momentum indicators can be looked at for signals that are in agreement with the stochastic oscillator to confirm its indication.