Technical indicators that give readings within a pre-defined range are called oscillators, and these work well in trading range periods. For example, Welles Wilder's Relative Strength Index (RSI) is derived from a formula comparing upward and downward moves, and only gives readings between 0 and 100. A high reading is defined as "overbought" and a low reading is "oversold." The reason oscillators such as RSI work well in trading range environments is that overbought situations are more likely to reverse lower and vice versa. If there is an underlying trend, oscillators that fight the trend will often be overpowered, making their signals useful only if they go with the trend.
The Relative Strength Index (RSI), an oscillator developed by Welles Wilder, measures the internal strength of a stock by monitoring changes in its closing prices. The formula for RSI is as follows:
RSI = 100 - [100/(1 + RS)]
RS = average of upward price change over a select number of days/average of downward price change over the same number of days.
As with the stochastic indicator, RSI fluctuates between 0 and 100. RSI peaks indicate overbought levels and suggest price tops, while RSI troughs denote oversold levels and share price bottoms. Absolute levels can vary in meaning from stock to stock and in different market environments.
Two horizontal reference lines are normally placed at 30 (indicating an oversold area) and 70 (indicating an overbought area). These reference lines can be adjusted depending on the market environment. Some analysts move these lines to 40 and 80 in bull markets (raising the bar, so to speak) and lower them to 20 and 60 in bear markets.
It is advised that traders use the "5% rule" - RSI spends less than 5% of the time beyond either reference line over a 6-month period. You can adjust these reference lines every 3 months (once per quarter).
There is no "holy grail" level dictating guaranteed overbought or oversold readings. RSI can stay overbought in bull markets and oversold in bear markets for prolonged periods. Like most indicators, you will become accustomed to using RSI, getting a "feel" for what works best for you.
RSI typically produces 3 kinds of trading signals, as outlined below in order of significance.
The most significant signal is generated on "bullish" or "bearish" divergences between the RSI and the price of the underlying stock. A bullish divergence gives a "buy" or long signal and occurs when the stock price makes a new near-term low, but the RSI makes a shallower trough relative to the previous decline. You would enter a long position as soon as the RSI turns upward from this second bottom. Place a protective stop below the stock's latest minor low.
The buy signal is especially strong if the first RSI low drops below the oversold reference line. This indicates that selling pressure is near exhaustion and a directional change (upward) is imminent.
A bearish divergence that gives a "sell" or short signal occurs when prices rally to a new near-term peak but the RSI makes a lower peak than during the previous advance by the stock. This calls for selling short or purchasing a put option as soon as the RSI turns down from this second peak. Place a protective stop above the stock's latest minor high. Sell signals are especially strong if the first RSI peak is above the upper or overbought reference line.
Classical charting methods work well if filtered with the RSI. The RSI indicator can be used to validate trendlines, support/resistance, and even reversal patterns. Since the RSI is a leading or coincident indicator (never a lagging indicator), it can be used to anticipate the completions of these patterns.
Buy/sell signals can also be obtained simply by following the RSI levels. These signals should be verified by the prevalent trend in the stock. As the RSI rises above the upper reference line, bulls are in control, but the stock is considered overbought and is likely vulnerable to selling pressure. When the RSI falls back below the reference line, a sell signal is generated.
If the RSI moves below the lower reference line, the bears are in charge, but the stock is considered to be likely oversold and entering a "buy" zone. When the RSI reverses back above the lower reference line, a buy signal is generated. (One word of caution – do not "fade" or bet against the prevailing trend of the stock or market.)
This use of RSI represents this most empirical (and probably least) effective use of the RSI. In this example, we simply attempt to gauge buy and sell points based on the overbought/oversold nature of the indicator. Stocks in a strong uptrend tend to stay overbought, while stocks in strong downtrends tend to hold their oversold RSI readings. Buying when the RSI turns up from an oversold area and selling when the RSI reverses from an overbought condition can allow a trader to profit from quick moves in either direction. Be cautioned, however, that this is the least effective use of this indicator.
Stochastic is an overbought/oversold technical indicator. If a stock or index is said to be oversold, there exists the possibility that buyers will enter the market, driving the issue price upward. On the other hand, if a stock is overbought, the odds increase that sellers will overpower buyers to drive the price lower.
In trending markets, Stochastic can stay overbought or oversold. In a strong uptrending market, the Stochastic can stay overbought, while in a strong downtrending market the measure can maintain its oversold condition. From a timing perspective, Stochastic works best in a non-trending or consolidating market.
The Stochastic Oscillator compares a security's closing price level to its range over a specified period of time. Generally speaking, prices tend to close near their highs in uptrending markets and near their lows in downtrending markets. As an upward trend becomes exhausted, these closing values tend to drift lower away from the highs. Conversely, as a downtrending market starts to stabilize, closing prices gradually move away from the lows.
The indicator attempts to determine when prices start to consolidate or "cluster" around their low levels of the day in an uptrending market or around their high levels of the day in a downtrending market. These conditions should indicate that a trend reversal is imminent.
The Stochastic indicator is plotted as two lines - the %D line and the %K line - with values ranging from zero to 100. Readings above 80 are considered strong and suggest prices are closing near their highs. Readings below 20 indicate prices are closing near their lows and are indicative of weakness.
Typically, %K will change direction before %D. However, when the %D line changes directions prior to the %K line, a slow and steady reversal is often indicated. When both %K and %D lines change direction, and the faster %K changes direction to retest a crossing of the %D line, but does not cross it, we have confirmation of the stability of the prior reversal.
A common misconception many traders have is when the indicator moves into extreme territory. When %K reaches 100 percent, for example, it does not mean that prices cannot move higher. Conversely, if %K moves to zero percent, prices can still continue lower. These extremes can denote strengths at the 100-percent level or weakness at the zero-percent level. The misunderstanding is perpetuated because the indicator is referred to as an overbought/oversold measurement. When the move in the stock is sustained, the indicator can remain at extreme levels for extended periods of time.
Occasionally, "divergence" appears on the charts. The price may be making higher highs, while the Stochastic is making lower lows. Conversely, the price may be setting lower lows while the oscillator is making higher highs. Listen to the indicator! It is telling you that the price will soon follow.
It is always wise to get a feel for the equity that you are following by moving from a short-term chart (daily) to an intermediate-term (weekly) chart and even to a monthly chart for a longer-term perspective. These observations can aid in your interpretation of the Stochastic.
Calculating Stochastic is done in several steps and is better done with a computer program. The first step is to obtain the "raw Stochastic" or %K, as follows:
%K=100*[(CL - LX)/(HX - LX)]
CL = the latest day's close LX = the lowest point over the past X days HX = the highest point over the past X days X = the number of days, typically five or more
%D represents a smoothing of %K and is typically a 3-day moving average of %K.
There are two types of Stochastic -- fast and slow. The fast Stochastic is simply %K and %D plotted on the same chart. It is subject to quicker moves and can catch more turning points, but is subject to greater "whipsaw" movement. The slow Stochastic, a less sensitive indicator preferred by many traders, goes a step further in the smoothing process. The %D of the fast Stochastic becomes the new %K, which is then smoothed once again using a 3-day moving average (typically) to obtain the new "slow" %D. The slow Stochastic is preferred for filtering out market noise and is less prone to violent whipsaws.
An important feature found in strong uptrending stocks is that the Stochastic can stay in an overbought area for quite some time. This brings up the importance of identifying the trend of the stock and not fighting it.
You can adjust the time frame or specific Stochastic to your trading style. For example, you do not need to conform to the 20/80 buy/sell zones. They can be tailored to suit the volatility in the stocks that you track (30/70 may be better in such cases). You can also "speed up" the indicator by shrinking your look-back period to 10 days (careful, you can get fake-outs here) or slow them down by going out to a 50-day look-back (although you may miss more of the move). Practice with a setting that you are comfortable with and stick with it. You cannot get a feel for the indicator if you are constantly adjusting it. Be aware of the particular stock's trend or lack thereof. Finally, don't rely solely on Stochastic; use additional filters in your trading (e.g., moving averages, regression lines). And don't forget your sentiment indicators.