Stencils are much more limited than other forms of printing, such as silkscreens, but their limitations lead to simplicity, and simplicity has its place. Stencils can be beautiful.
Applying the stencils can be a good party activity. You bring the stencils and the spraypaint or ink/roller/iron, and ask each guest to bring something that they want stenciled. That can keep people amused for hours.
Choosing a stencil material
If you're only going to use a stencil a couple dozen times, then you can cut the stencil out of thin cardboard.
If you're going to use the image a lot, then you'd be better off with a material that can't absorb liquids. I like to use the rubbery stuff that refrigerator magnets are made from. I've also used thick foil with good results, though that takes a lot of effort. (I think the foil was originally intended for use as heat shields around house heaters).
Art supplies shops sell the more expensive oiled stencil paper (at least they do in the UK) in which it is fairly easy to cut lettering for body slogans. See also body painting info in United_Kingdom_FAQ.
Making the stencils
Get a stencil image you like, scale it to the size you want, and then tape it to the blank stencil material. Cover the entire stencil image with tape, because otherwise the paper will tear as you're cutting through it.
So, yeah, the next step is to cut around the edges of the stencil image. If you have a choice, it's better to overcut into the waste material (the part that you're removing to allow paint/ink through) rather than the part of the stencil you want to keep. If the stencil has long thin lines, like the "legs" logo below, then be very careful with those. They can rip very easily. I suggest you make those cuts first, partly so that if you mess up you haven't destroyed an hour's work, and partly because the stencil material is strongest when its whole, so you're less likely to tear it.
A utility knife is best for long straight or slightly curving cuts. An xacto knife is useful for small details, and the last 2mm before a vertex that the larger knife never seems to get right.
Be careful. Never pull the knife toward your fingers. I know that sounds astounding obvious, but when you're trying to make a perfect cut there's a tendency to think about where the edge is, and not necessarily where it'll end up if it slips. Watch out for that.
Using the stencils
There are basically two ways to use stencils on fabric: you can use spray paint, or you can use rollers and silkscreening ink. Using stencils on skin is quick and simple by just sponging on dampened face paint (e.g. Snazaroo).
Spray paint is messy, but fast. If you need to make a lot of images, then spraypaint may be your only option. Because of the fumes, you should only do this outside (unless you happen to have access to a specially ventilated spraypainting room). Spraypaint tends to fade when washed. Also, if you're applying the stencil to fabric then you'll find that some paints soak right though the fabric without leaving the nice clear mark that you hoped for. Metalic paints seem to work best of fabric. Many short burst of paint work better than a single long spray.
The ink and roller method is slower and more complicated. You need to mix the inks and a fixer (also known as "GAK"), roll it through the stencil onto the object you're stenciling, wait for it to dry, and then iron it with high heat for about 10 minutes to fix the ink to the fabric. If you do it right, the ink will last as long as the fabric.
Either way, you'll need to stop and clean the stencil periodically. With the roller method, the ink will accumulate on the underside of the stencil which leads to blotchy images. With spraypaint, smaller details will get clogged.
You can get creative by overlapping different images in different colors. This works for both spraypaint and ink. Either way, you need to wait for the first color to dry before you apply the second color. With ink, you do not need to do the 10-minute ironing between colors though, which is certainly nice.
For spraypaint only, you can get a cool "halo" effect by first holding the stencil about 4mm above the surface and painting it it one color to get a fuzzy image. When that dries, use the stencil in the normal way to lay down a sharp image in a different color.
A simple "legs" logo. We're using this to stencil neckties to give away as souvenirs at the 2007 Portland ride. (T-shirts didn't seem appropriate for a naked ride. Fanny packs did seem appropriate, but much too expensive for 800 people.) We got the ties from Goodwill for a very low price.