An "understanding" of the stomaster by author Jim Grauer.

http://www.stomaster.com/stodolie.pdf

TECHNICAL ANALYSIS AND THE INTEREST RATE CYCLE

The term "stochastic" in statistics refers to random or chance variables, or that which involves chance or probability. The price behavior of all cash and commodity instruments embodies those descriptions and were duly noted by Dr. George Lane nearly 40 years ago. Lane observed that as the level of the price of an instrument continued to rise or fall, its closing price tended to be closer to the top or bottom of the range, respectively. In an attempt to rationally quantify this empirical dynamic, he constructed a formulaic process by which a stochastic or "educated guess" as to the direction of an instrument's price could be confidently applied and designated it as "Stochastic Process".

How is the formula for the Stochastic Process determined?

The Stochastic is always measured through the relationship of two lines, %K and %D, which determine the relative overbought or oversold condition of a traded instrument in its particular market. As %D is a moving average of %K, the latter, represented by a solid line, will always appear "faster" than the former, depicted as a dashed line.

In its simplest form, the Stochastic variable, or %K, is derived in the following manner:

%K = 100[(C-L)/(H-L)] where C = Close; H = High; L = Low

By construction, it is evident that %K may vary from 0 to 100%, measuring the closing price as a percentage of the total range. Depending on the time frame desired, %K may represent this relationship for a selected number of minutes, hours, days, weeks months , years, or any other interval.

The Stochastic variable %D is simply a moving average of %K and will, therefore, describe the identical movements of %K on a lagged basis. Other common references to the Stochastic such as "Slow Stochastic", "Smoothed Slow Stochastic", "Exponential Slow Stochastic" are no more than statistical techniques applied to the basic Stochastic in order to enhance its prognosticative value and to filter out extraneous and distorting statistical "noise".

How is the Stochastic interpreted?

The Stochastic is constructed as an oscillator, cycling periodically between overbought and oversold conditions. An overbought condition is signaled when it rises beyond the 80-85% zone, while an oversold condition is indicated when it falls below the 10-15% level. A sell signal is triggered from an overbought condition when %K crosses down through %D and the converse from an oversold position. The validity and authority of either signal is enhanced when the cross of %K is effected after the apex or nadir of %D, respectively. Divergences, bullish or bearish also figure prominently into the presumption of strength in the ensuing move. A bullish divergence occurs when %D forms two declining peaks while the price of the instrument moves higher and the converse for a bearish divergence.

The optimal signal is triggered when a leading %K cross occurs in an extreme zone accompanied by a divergence

The Stochastic variable %D is simply a moving average of %K and will, therefore, describe the identical movements of %K on a lagged basis. Other common references to the Stochastic such as "Slow Stochastic", "Smoothed Slow Stochastic", "Exponential Slow Stochastic" are no more than statistical techniques applied to the basic Stochastic in order to enhance its prognosticative value and to filter out extraneous and distorting statistical "noise".

How is the Stochastic interpreted?

The Stochastic is constructed as an oscillator, cycling periodically between overbought and oversold conditions.

An overbought condition is signaled when it rises beyond the 80-85% zone, while an oversold condition is indicated when it falls below the 10-15% level. A sell signal is triggered from  an overbought condition when %K crosses down through %D and the converse from an oversold position. The validity and authority of either signal is enhanced when the cross of %K is effected after the apex or nadir of %D, respectively. Divergences, bullish or bearish also figure prominently into the presumption of strength in the ensuing move. A bullish divergence occurs when %D forms two declining peaks while the price of the instrument moves higher and the converse for a bearish divergence.The optimal signal is triggered when a leading %K cross occurs in an extreme zone accompanied by a divergence.