A great complement to a trend-following or momentum-based strategy is one that is counter-trend. A counter-trend strategy utilizes technical indicators, such as the stochastic oscillator, to identify when a security is becoming overbought or oversold. We see an overbought condition as a natural byproduct of positive momentum, but it eventually takes its toll. Conversely, we see an oversold condition as a byproduct of negative momentum, but it eventually provides opportunity. The stochastic oscillator measures the level of the closing price relative to the high-low range over a specific period. The default tends to be 14 periods, but we prefer to use 12 periods because we find 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, a smoothed average of %K. The indicator oscillates between 0 and 100%. When a security is less than 20%, it is deemed oversold, and when it is above 80%, it is overbought. Helpful 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 was maintained for nearly a year (November 2020-October 2021). When the %K (blue line) crossed back below 80% in November 2021, a “sell” signal was generated. Past sell signals are denoted by the red arrows on the chart and opposing “buy” signals are denoted by the green arrows. In our work, a buy signal requires an upturn in the %K line above 20%. A common occurrence is what we call an “oversold retest”, where the stochastics see an oversold upturn above 20% but briefly turn lower before turning higher again in a whipsaw. This happens oftentimes during a basing phase, which was the case for IWM during second half of 2022. Due to the fractal nature of technical analysis, we can apply the stochastic oscillator on any timeframe, such as the weekly bar chart for IWM. On the weekly chart, it is evident that the stochastic oscillator is more effective as a standalone indicator in a trading range environment, given the timeliness of the buy and sell signals from mid-2022 to late 2023. We can drill in further and look at a short-term timeframe via the daily bar chart. One other thing to consider when using the stochastics is the prevailing trend. When a buy or sell signal occurs in the direction of the prevailing trend, it often has a greater probability of working. Recently, the daily stochastics saw an oversold upturn above IWM’s rising 200-day moving average, which has resulted in a bounce. At Fairlead Strategies, we consider all three timeframes for a directional bias. Starting with the long term, IWM saw a monthly overbought downturn in June, but it was left unconfirmed since it spent only one month below 80% (i.e., an unconfirmed signal) so we are deferring to positive long-term momentum. In the intermediate term, the outlook has weakened given the recent overbought downturn in the weekly stochastics. In the short term, IWM has room for a bigger bounce since the stochastics point higher with room to overbought territory. In conclusion, the stochastic oscillator can help traders gauge when a trend is becoming overdone on the upside or downside. It is best combined with other technical tools, such as support and resistance, momentum indicators, and market internal measures. —Katie Stockton with Will Tamplin Access research from Fairlead Strategies for free here . DISCLOSURES: (None) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another 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 CONSITUTE FINANCIAL, INVESTMENT, TAX OR LEGAL ADVICE OR A RECOMMENDATION TO BUY 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 MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
