WHAT WORKS, WHAT DOESN'T, AND WHY

GENERAL DISCUSSION:

Overbought (OB) and Oversold (OS) are among the least understood market conditions that traders grapple with. Most lose money attempting to utilize what they know about the subject. This is not surprising, because we're getting into the use of coincident and Leading Indicators and very few traders are properly prepared for the challenge these concepts present. Because of the level of misunderstanding, instead of narrowly defining what I use and how I use it, my approach will be to discuss the broad topic of Oscillators in general: what works, what doesn't, and why.

Typical thinking about Oscillators can be summed up by the following comment. "Oscillators work in a consolidating market, but once a Trend starts, they don't work at all." While this thinking may be typical, it severely limits and distorts a wealth of important trading strategies. The idea behind the statement goes something like this. You can sell Overbought and buy Oversold, as long as the market is consolidating and... you would expect to make money. This "sound good, feel good" strategy implies that you can identify when a market is consolidating with enough certainty to place orders. Does anyone want to try the ADX Average Directional Movement Index 1 as a means of making this judgment? While this approach may be acceptable for some ofyou, it's not for me. I

1 J. Welles Wilder Jr., New Concepts in Technical Trading Systems (Trend Research, 1978), hereafter cited parenthetically in the text as Wilder, New Concepts.

haven't found it to be sufficiently accurate in this context, particularly for intraday charts. What about the second part of this statement?

"Once a Trend starts, they (Oscillators) don't work at all." The idea here is that the initiation of orders against the prevailing Trend will likely result in losses, by your stops getting hit.

The real problem with the initial statement is inherent in the way works is defined. I intend to show you how the right Oscillator can be made to work for you, in a wide variety of market situations.

Before we discuss uses and potential benefits however, let's first discuss which Oscillators are most commonly used, and which are best to use in the context of an Overbought/Oversold indicator.

THE STOCHASTIC

The Stochastic is one of the most consistently misused indicators in the trader's arsenal. Traders typically consider any move over 75 to be Overbought and any move under 25 to be Oversold. That's not what George Lane (its originator) teaches and that's exactly the opposite of what Jake Bernstein's research of the Stochastic Pop Indicator 2 tells us. In fact, according to Jake's research, fully 50% of a strong market move can take place after the 75/25% barriers have been crossed!

In the daily treasury bond Chart 7-1, there are two places, marked by vertical lines, where you would have been killedbuying in excess of 25% Oversold. Note, this is the case even though I have used the more typical (stronger) 14 period Stochastic, rather than what I described to you in CHAPTER 5. Further complicating the issue for new traders is the fact that in strongly trending markets, the Stochastic may never see these extreme (75%/25%) levels on typical retracements of an ongoing Trend. If you were waiting for these levels, you'd likely never get the opportunity to sell in a strong down trend or buy in an strong up trend.

Overbought & Oversold Oscillators

MACD:

Other traders use the MACD (Moving Average Convergence Divergence) to indicate extremes in market Movements, or worse yet, as a divergence tool. As you know from CHAPTER 5, this is a cleverly designed and highly capable Trend-indicating Oscillator, not an Overbought/Oversold tool. There is, however, an innovative technique (Bernstein, Short Term Trading) of using the distance between the slow and fast lines of the MACD as an Overbought and Oversold indicator. In my opinion, however, there is a much better way to accomplish this.