What’s the Best Overbought / Oversold Indicator?
Now and then I get asked what are the best technical indicators to use in trading. I know some of you out there are endlessly hunting for the holy grail of technical indicators that’ll get you in and out of trades flawlessly every time. If you find it let me know, and in the meantime here are a few rules of thumb:
1) It’s never a good idea to make trading decisions based on a signal from a single indicator. Technical indicators work best when you use them together, and as one part of a broader trading plan.
2) The best trading plans are simple, using a small number of solid technical indicators along with a few other proven tools and techniques. Too many indicators on a chart confuses things, sometimes even giving contradicting signals.
3) Popular technical indicators are popular because they work (and also because if enough people use them, they can become a self-fulfilling prophecy).
4) And the most critical rule of thumb: It’s at least as important, if not more-so, to know how to use overbought / oversold indicators as it is to know which are the best to use.
That last point is significant, so let it sink in. A better question for this article might be What’s the best way to use overbought / oversold indicators in my trading practice?
As you might know, overbought / oversold oscillators are leading indicators. In other words, they try to predict what price will do in the future. For example, when a security that has been trending up for awhile dips down and an indicator signals that the security is “oversold,” there’s a good chance that price will soon spring back up into the trend. A buying opportunity could be right around the corner.
But we don’t take it for granted that a signal from one single indicator, especially a leading indicator, is enough to get us into the trade. Securities can stay in an overbought or oversold condition for a long time. An overbought or oversold signal simply triggers us to keep an eye on a trending security to see if it actually does start to go back into the trend.
And if that happens, we look at a few other things to validate that this is a good trade. Is there enough volume to show that there’s strength in the movement back into the trend? Is there significant resistance or support in the way that might keep us from making the trade? Is there any upcoming event around the security’s company, like an earnings announcement, that could throw off price unpredictably? Etc.
Getting back to the original question, which overbought / oversold indicator do I like best? In my trading, I mostly use the Williams %R. The Williams %R, a popular indicator created years ago by author and leading trading expert Larry Williams, works by showing the current closing price in relation to the high and low of the past N (typically 10) days. Readings on the indicator range from -100 to 0. Readings in the upper range, from about -10 to 0, indicate the security is extremely overbought while readings from about -90 to -100 suggest it’s extremely oversold.
When the Williams %R shows an extreme overbought or oversold condition in a trending security, it’s time to watch for that security to kick back into the trend, and then use your other trading tools and techniques to confirm whether this is another potential profitable trade.
If you want to know more about the Williams %R or other technical indicators, a good resource is The Equis International site
Dave Pezzutti @ 5:58 am:
A.J. Best indicator to judge overbought - oversold condition is Bollinger band width (BBW).
The BBW is a statistical differential measure of price to moving average over a set period.
It is ideal for trading options becaaue it identifies setup conditions for reversals, confirms and identifies action trigger, and indicate volatility changes.
Dave
Karen @ 12:11 pm:
Great blog. I like the “step by step” reasoning and rationale
John Crawford @ 6:24 pm:
Am extremely appreciative of your videos attempting to show how to apply a strategy especially at the right hand edge of the chart. As you said, you were all over the board on the vertical spread narration. But this is somewhat understandable in video of just a few minutes. Too many people who may be great at explaining options strategies, fall way short in explaining how to find the right stocks at the right(high probability - not perfect)time for actually applying the strategies and combining all of that with determining actual entry and, ultimately, position management techniques. This is ABSOLUTELY necessary to make even the most expert knowledge of options inner workings effective for actual trading, in my opinion.
I am also an Engineer. I am also desirous of confirming if the standard buy and hold method of investing can be beaten and, in fact, if extraordinary returns can be achieved through options and among other vehicles. And, if achievable, I want to be able to take certain family/friend/acquaintances successfully through the process given that most of them will require a very hand holding approach that will allow them to master what may be a “complex” process but through small step by step advances along the path.
If your methods can achieve this and can be pared down to reasonably straight forward steps in an overall process that does not require “one more course”, “one more school”, “…oh, you need the extra program”, and rapid fire additions of teaching and associated “add on” costs, I would be very interested in seeing more of your program.
Thanks once again for the videos.
MIKE SMITH @ 5:11 pm:
AS ALWAYS GREAT INFORMATION
Carmen @ 7:25 am:
Fantastic blog and I love your web site… very informative for novices and experts alike!
peter @forex options @ 3:21 am:
I really appreciate your post, it is very helpful.
Dean @ 5:31 pm:
I like to wait until stochastics is overbought (>80) for longs, and oversold (<20), for shorts, which surprises a lot of my subscribers. If a good trend is in the works, these overbought/sold conditions last for quite some time
joe @ 7:42 am:
this is my first time on your blog. your site is very good and i’m looking to come on in the future. i use the bbw.rsi.s.sto.,f.sto,and macd.and ma.
Fred Robertson @ 7:18 pm:
I like the blog. Very detailed and informative information regarding use of momentum indicators to help with trading entry exit definition. Will be reading more here for sure. Fred
Brad @ 9:43 pm:
I think that the best overbought oversold indicator and a reversal signal is when lets say a stock is in an up trend than for a couple of days in bound-range.
the signal comes with a sudden PUT/CALL ratio change with a significant volume.