These indicators fluctuate from one extreme to another, indicating overbought conditions, i.e. buyers have been over enthusiastic or oversold conditions with the sellers being over enthusiastic. It is likely that from any of these extremes the share will reverse.
The 3 Indicators we'll be looking at today are:
- Stochastics;
- Relative Strength Index (RSI); and
- Williams %R
Stochastic
Mathematicians have come up with a formula which always oscillates between 0 and 100 to standardize buy and sell levels for all shares, irrespective of volatility or price. The value of the stochastic indicator on any given day is the position of the closing price in percentage terms relative to the high and low of the trading range.
The number of days over which the stochastic is calculated varies with short term traders using 5-25 days and medium term traders more than 25 days.
The stochastic is based on the premise that closing prices tend to accumulate near the tops of each period’s trading range during price up-trends and at the bottom during price downtrends. As a downward trend turns into an upward trend, bullish sentiment gains momentum and you will find that the share begins to close closer to its high than its daily low.
Buy the share when the oscillator (either %K or %D) falls below a specific level (e.g., 20) and then rises above that level or buy when the %K line rises above the %D line. A sell signal occurs when the Oscillator rises above a specific level (e.g., 80) and then falls below that level or sell when the %K line falls below the %D line.
Also look for divergence between the price trend and the stochastic trend. If prices are making a series of new lows and the Stochastic Oscillator is failing to surpass its previous lows this indicates a buy signal. A sell signal occurs when prices are making a series of new highs and the Stochastic Oscillator is failing to surpass its previous highs.
Relative Strength Index
RSI is really a measure of the internal strength of a share. The RSI monitors the speed of movement of the share NOT the ratio of a share to another share or to a market index. When Wilder introduced the RSI, he recommended using a 14-day RSI. Since then, the 9-day and 25-day RSI have also gained popularity.
The fewer days used to calculate the RSI, the more volatile the indicator. For short-term trading 9, 7, or even 5 days are used. The RSI is an overbought/oversold indicator. It fluctuates between 0 and 100 however is unlikely to reach these extremes. Overbought is normally interpreted as greater than 70 and oversold is less than 30.
If the RSI is below 30, a good buy signal will be given when the RSI rises above the previous peak. An alternative but less reliable buy signal is generated by the RSI crossing above the 30 line. If the RSI is above 70 a good sell signal will be given when the RSI falls below its previous trough. An alternative but less effective sell signal is generated by the RSI crossing down through the 70 line.
If there is divergence the price would have made a new low which is not confirmed by the RSI. The RSI would form a double bottom, or preferably two successive rising troughs. This is a warning of an imminent reversal in the price trend.
Look for divergence in the slope of the lines between RSI and the price line in the area below 30 to generate a buy signal and look for divergence in the slope of the lines between the RSI and the price line in the area above 70 for a sell signal.
Williams % R
Williams %R is one of the fastest oscillators that has been developed and is very responsive to price action.
The formula used to calculate Williams' %R is similar to the Stochastic Oscillator. Williams' %R is plotted on an upside down scale with 0 at the top and 100 at the bottom. To show the indicator in this upside down fashion a minus symbol is placed before the %R values.
You should ignore the minus symbol. The shorter the time frame the more volatile the indicator. Very short time frames under 5 days provide very frequent signals and many false signals.
The analysis of Williams' %R is very similar to that of the Stochastic Oscillator except that %R is upside down and the Stochastic Oscillator has internal smoothing. Readings in the range of 80 to 100% (remember to ignore the minus symbol) indicate that the market is oversold, while readings in the 0 to 20% range suggest that the market is overbought.
A buy signal is generated when the Williams %R crosses above the -20 line from below. A sell signal is generated when the Williams %R crosses down through the -80 line from above.
If there is divergence the price would have made a new low which is not confirmed by the Williams %R. The Williams %R would form a double bottom, or preferably two successive rising troughs. This is a warning of an imminent reversal in the price trend.
An interesting phenomenon of the %R indicator is its uncanny ability to anticipate a reversal in the underlying share's price. The indicator almost always forms a peak and turns down a few days before the share's price peaks and turns down. Likewise, %R usually creates a trough and turns up a few days before the share's price turns up.
