Created by George C. Lane in the late 1950s, the Stochastic Oscillator is a momentum indicator that shows the location of the close relative to the high-low range over a set number of days or periods. The Stochastic Oscillator does not follow price, it does not follow volume or anything like that. It follows the speed or the momentum of price. It works because momentum changes direction before price.

If you pull up a current chart of the DOW, and add a Slow Stochastic Oscillator, a Fast Stochastic Oscillator, and an ADX, it will be easier for you to follow along in this lesson.

New traders freak out when they hear all the options presented to them regarding the Stochastic Oscillator. They hear Fast, Slow, Full, %K, and %D. In fact, there are 24 possible settings regarding Stochastic Oscillators and %K and %D settings. Don't freak out. I'm going to make this very simple and not try and wow you with my knowledge about the subject.

You should be using the Slow Stochastic Oscillator, not the Fast or the Full.

Now some of you are just going to say cool, and accept my proposition that you should only be using the Slow Stochastic while others are going to demand to know why and want to argue that point with me. So for the second group, I'm going to tell you my reasoning behind saying that the Slow Stochastic is the way to go.

The Fast Stochastic Oscillator is based on George Lane's original formulas for %K and %D. %K in the Fast Stochastic appears rather choppy and %D is the 3 day SMA of %K. In fact, Lane used %D to generate either buy or sell signals and not %K. In fact, Lane asserts that a %D divergence is the only signal which should cause you to buy or sell. So %D on the Fast Stochastic is used for signals. The Slow Stochastic was created to reflect this emphasis. All the Slow Stochastic Oscillator does folks, is that it smoothes the %K with a 3 day SMA. That's it. That's all it does folks.

As for the Full Stochastic Oscillator, that's nothing new either. It just opens up all the formulas on the Slow Stochastic for those of you that want to tweak the settings.

Now here's the way I use the Stochastic and you need to as well. Between December of 2010 and March of 2011, the Stochastic was useless. It gyrated above the 80 line and didn't give any useful signals. This is what always happens to the Stochastic Oscillator when we are in a trending market. The trend is not the oscillator's friend. For any oscillator to work, you need to be in a trading market. Oscillators rock in trading markets. Oscillators suck in trending markets.

In a trending market you should not be using the Stochastic Oscillator. You should be using trend indicators like moving average crossovers, support and resistance, the MACD, and the money flow. There are indicators that you can use in a trending market that are going to work better than oscillator based ones.

So the secret to using the Stochastic Oscillator to make huge profits is in establishing whether we are in a trending market or a trading market. You establish that by use of the ADX indicator.