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A great complement to a trend-following or momentum-based strategy is a countertrend strategy. A countertrend strategy uses technical indicators, such as the stochastic oscillator, to determine when a security is overbought or oversold. We see overbought conditions as a natural byproduct of positive momentum, but they ultimately take their toll. Conversely, we see oversold conditions as a byproduct of negative momentum, but they ultimately provide opportunity. The stochastic oscillator measures the closing price level relative to the high and low range over a specified period of time. The default tends to be 14 periods, but we prefer to use 12 periods because we find that the frequency of signals aligns well with our methodology. The stochastic oscillator consists of two lines: %K, which represents the current price relative to the range, and %D, which is a smoothed average of %K. The indicator oscillates between 0 and 100%. When the stock is below 20%, it is considered oversold, and when it is above 80%, it is considered overbought. Useful signals are generated by the stochastic oscillator when a crossover occurs. For example, on the monthly chart of the iShares Russell 2000 ETF (IWM), a long-term overbought condition has been maintained for almost a year (November 2020-October 2021). When %K (blue line) crossed back below 80% in November 2021, a “sell” signal was generated. Previous sell signals are indicated by the red arrows on the chart and opposing “buy” signals are indicated by the green arrows. In our work, a buy signal requires a rise in the %K line above 20%. What we call an “oversold retest” is a common occurrence, where stochastic indicators experience a sell surge above 20% but then briefly pull back before rising again in sharp swings. This often happens during a baseline phase, as was the case for IWM during the second half of 2022. Given the fractal nature of technical analysis, we can apply the stochastic oscillator to any time frame, such as the weekly chart of IWM. On the weekly chart, the stochastic oscillator is clearly more effective as a standalone indicator in a range trading environment, given the timing of buy and sell signals from mid-2022 to late 2023. We can dig deeper and look at a shorter-term time frame via the daily chart. Another thing to consider when using stochastic indicators is the prevailing trend. When a buy or sell signal occurs in the direction of the prevailing trend, it often has a higher probability of success. Recently, the daily stochastics have seen an oversold rise above the IWM’s 200-day moving average, leading to a bounce. At Fairlead Strategies, we consider all three time frames for directional bias. Starting from the long-term, the IWM saw a monthly overbought decline in June, but it was not confirmed as it spent only one month below 80% (i.e. an unconfirmed signal) so we defer the long-term positive momentum. In the medium-term, the outlook has weakened given the recent overbought decline in the weekly stochastics. In the short term, the IWM has room for a larger bounce as stochastics point higher with room for overbought territory. In conclusion, the stochastic oscillator can help traders gauge when a trend is overbought to the upside or downside. It is best combined with other technical tools, such as support and resistance, momentum indicators, and internal market metrics. —Katie Stockton with Will Tamblyn You can access research from Fairlead Strategies for free here. Disclosures: (None) All opinions expressed by CNBC Pro contributors are their own and do not reflect the views of CNBC, NBC UNIVERSAL, its parent company or its affiliates, and have been previously published by them on television, radio, online, or any other medium. The above content is subject to our Terms and Conditions and Privacy Policy. This content is provided for informational purposes only and does not constitute financial, investment, tax, or legal advice or a recommendation to purchase any security or other financial asset. The content is general in nature and does not reflect any individual’s unique personal circumstances. The above content may not be appropriate for your specific circumstances. Before making any financial decisions, you should carefully consider seeking advice from your own financial or investment advisor. Click here for full disclaimer.
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