the most common use. The underlying idea is that a market will not normally
move in one direction or the other for very long without running out
of buyers, in a bull move, or sellers, in a bear move. If the market shoots up
sharply, without a retracement, then the market is considered overbought.
Conversely, a sharp drop in price, without a retracement, will lead to an
oversold market.
The basic theory is that prices cannot go too far too fast. If they do,
then they are ripe for a retracement. The retracement is necessary to
“correct the overbought situation.” A market that has shot up quickly has
moved the price of the pair away from the underlying value too quickly. As
a result, the market will set back slightly to induce more buying into the
market.
The concept of overbought and oversold is mainly used to try to predict
short-term price movements against the trend. It is also used to help dissuade
traders from buying the market after the market has moved strongly.
It is used to encourage traders to wait for a setback before buying.
In general, the concept of overbought and oversold works. Typically,
when the stochastics get above 80 percent, the market is overbought; when
stochastics get below 20 percent, the market is oversold. You should normally
expect a correction to ensue relatively soon. This is the way that
most people use stochastics. However, just because it generally works and
calls corrections accurately doesn’t mean that it is profitable. In fact, selling
when stochastics get above 80 percent and buying when stochastics get
below 20 percent is a money-losing strategy.
Some people modify the method and sell when the stochastics get
above 80 percent and the %K crosses down below the %D and buy when
the stochastics get below 20 percent and the %K crosses above the %D.
This works better but is still a money-losing strategy.
The problem is strongly trending markets. Using stochastics as an overbought/
oversold indicator falls completely apart. In other words, the concepts
of overbought and oversold work during mild trends and sideways
markets but do terribly during trending markets. In fact, some people have
suggested that you are better off buying when the %K crosses above the
80 percent line and selling when the %K crosses down below the 20 percent
line. This is actually better than what we have been talking about, but
it also loses money.
First, you must determine what kind of trader you are before using
stochastics as an overbought or oversold indicator. You should consider
using stochastics if you are the type of trader who wants to buy dips and
sell rallies in trendless markets, and is willing to lose when the market
finally starts to trend. If you are a trend follower, then you should ignore
the stochastic overbought and oversold reading. Stochastics will register
an overbought reading for weeks during a major explosive bull market.
The more explosive, the more the indicator will falsely be considered
overbought.
Figure 5.1 is a good example of what I have been talking about. The
market became overbought in mid-December and the market continued to
skyrocket. On the other hand, the oversold conditions in February showed
some promise as profitable trades.
The bottom line is that it is dangerous to trade just because the stochastics
have moved to overbought or oversold. There needs to be some trigger
to tell you when the buying has actually begun to dissipate. Otherwise, you
will often be selling into a strong market with strong momentum. You know
you are selling into a strong market when you sell an overbought market
but you want to have a sign that the momentum is waning and the retracement
is now going to occur. The crossover is that signal.
Let me show you how to really drill down on using crossovers as signals.
I told you that this is not a profitable method to use mechanically, so
be careful. However, there are times when you can use it to your advantage.
I’m going to drill down to show you some nuances when you’re using
this technique. But don’t make this a primary technique—it’s dangerous!
Source: How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
