Option Investor
Trader's Corner

'Oscillators' (Part 1)

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Ever wonder why you see the Stochastics indicator on a lot of the charts shown in your Option Investor Daily? And the 'MACD' (pronounced 'mackdee') on other charts; or, on the same chart. And, in the charts I show below and generally in my columns, you nearly always see the Relative Strength Index (RSI) at bottom.

These 3 popular technical indicators each basically show the same three things: direction of price momentum, how strong that momentum is (steepness of the line) and something called 'overbought' or 'oversold' by use of those upper and lower lines; what use is that?

If you haven't experienced getting 'killed' in options because you bought puts when either Stochastic, RSI or MACD indicators suggested that an Index or Stock was 'overbought', you may have a sadistic 'treat' in store for you.

Buying calls when these indicators are down near the low end of their 1-100 'scale' (Stochastics and RSI) or when MACD got near a prior low (when prices rallied back when), has been part of some of my early trading disasters.

Then, why the heck use them? Should you pay attention to these; or, are they just 'noise'? I will discuss each in turn (some on stochastics today) but not all at once, keeping it (relatively) short and trying to make the discussion strictly relevant to their possible usefulness to you in assessing market or stock trends. In and of themselves, these technical indicators are of limited use/usefulness in making trading decisions. But, first up, a look at:

In my weekend Index Traders (web LINK to this found at bottom of this article), I was looking for the ability of key indexes to hold prior lows and for the likelihood of a short-term rally based on a short-term oversold condition suggested by hourly RSI indications; there are those terms, 'oversold' and 'RSI' again!

First are TRENDLINE considerations. Since the Dow 30 stocks got back somewhat in favor again recently, the Dow Average (INDU) has taken on a somewhat more key role in assessing the current up trend, as to the market staying within an overall UP trend and making guesses has to how far this current correction will carry (or, when the trend would reverse).

Bullish price action relative to trendline considerations in the current sideways to lower move is that INDU 'held' its daily up trendline. From my weekend Index Trader column, I suggested that 'key' support was 10730. Today's low was 10740 and the trendline is shown on the INDU daily chart below:

I would note the close (just) over the 21-day moving average, which is a bullish plus also. Of course, it's one thing to hold above a prior low, or at a trendline and another to break out above persistent overhanging resistance. Stay tuned on that!

Shown above is the Stochastic indicator and it tends to be the oscillator 'type' (more on this further on) indicator I look at for the Dow 30. I find that the Stochastic 'works' well in suggesting the area of the occasional intermediate highs and lows that I like to trade using the Dow Index calls and puts. As important as the indicator is the LENGTH setting. I always show this by writing it in; i.e., '21-day'.

At the blue up arrow, the lower 21-day stochastic line got to, although not really under (unlike some of the past bottoms), the lowermost (red) level line. This suggested that at the prior dip to the up trendline, according to the Stochastic indicator, INDU was at/near to 'oversold' (as defined by my 'length' input and my SETTING on the lower line where I set oversold as '15').

The 'default' settings for 'overbought' and oversold level lines for most charting applications for their ('Slow) Stochastic indicator is at 80 and 20.

If you see a Stochastic indicator that shows just below it "(10(5),3)", the key number is the FIRST number (10), that of 'length'; meaning HOW MANY closes it uses to calculate the Stochastic number. (You can mostly disregard the other numbers.)

If that first number is '5', used on a Daily chart, the Stochastic is looking at 5-days, a very short-term measurement; if length is set to 13, the stochastic formula is calculating more than 2 weeks (10 trading days) of closes and the indicator is then calculating trend momentum on a longer timeframe.

I use '21' above as my length setting, which then calculates slightly more than 4 weeks (20 trading sessions) in the case of a daily chart (21 hours in the case of an hourly chart, etc.) and is a 'fibonacci' number (e.g., 5, 8, 13, 21, etc.) and which I have found highlights the intermediate trend quite well on THIS particular indicator, Stochastics.

The S&P 100 (OEX) Index did dip yesterday (2/7) to just below prior important hourly lows in late-December, by reaching the 569 area briefly. However, the rapid rebound back above these lows, sets up a possible double-bottom low, which is an important indication for a significant bottom. Yet to come however, is the ability to pierce and stay above the hourly down trendline intersecting currently around 578. Stay tuned on that.

On the Relative Strength Indicator on my hourly charts, I also use a 'length' setting of '21'; so, applied to an hourly chart, the RSI formula is calculating the last 21 hourly closes. On this basis, the RSI did not register at 30 or below on the recent apparent bottom at the blue UP arrow on the OEX chart above, using the common RSI 'default' setting of 70 and 30 (as the level lines suggesting 'overbought' and 'oversold').

I often see that when prices get 'fully' oversold, fully overbought, subsequent trend reversals are strong and prolonged. However, as with all this stuff it's all relative. On the last peak in the hourly RSI Indicator at the blue down arrow on the OEX hourly chart above, RSI was not fully 'overbought' either, as evaluated by an upper 'overbought' line setting at 70. However, at that juncture hourly prices were in a declining trend (lower rally highs) and the down TRENDLINE, coupled with a relatively high RSI reading, were the key, combined, bearish aspects.

If we look at the OEX chart, we need also look at the S&P 500 (SPX) chart below, as SPX has been the leading index in advance of recent weeks and months. On the recent hourly decline below 1260 in SPX, which pierced the mid to late-Jan. lows, SPX appeared to be heading to a re-test of the key late-Dec. low around 1246.

Instead, SPX reversed at a point that touched and defined another trendline; that of the possible lower end of a downtrend channel, suggesting at least minor, if not 'final', support. The subsequent rebound back above the prior lows around 1260, was a bullish chart development. Yet to come is what happens at the down trendlines noted by the red (down) arrows.

Since uptrends consist of rising or equal (a 'double bottom') lows, price action over the next few days should be watched closely as whether this recent rebound is going to mark an important low. It at least looks like a promising trade for any who bought NDX calls when prices reversed back above the minor hourly down trendline by today's opening and low above 1652.

Also of course, the latest decline did not pierce the important late-December low around 1634 and this latest rebound and upside reversal was above that area, which is bullish.

Speaking of reaching or not reaching upper or lower, overbought or oversold, extremes, there was one major trading index that DID reach a 'fully' oversold short-term (hourly) RSI extreme, as seen on the Nasdaq 100 hourly chart (NDX) above.

The Nasdaq Composite (COMP) achieved a double bottom low in the 2240 area, making this hourly chart the most bullish of the hourly charts shown above. COMP did not get 'fully' oversold so to speak. But, as patterns often occur or can be looked at in pairs, the top in COMP that formed in the 2312 area, was not accompanied by an overbought extreme.

At the time of the aforementioned COMP top (2312) top, there were a number of highs in the same area forming a 'line' of resistance showing consistent selling pressure, AS WELL AS a bearish 'divergence' with the 21-hour RSI as ITS trend was declining, as highlighted by the down-sloping (cyan) RSI trendline shown above.

A key reason why I use the Relative Strength Index (RSI) much more than the Stochastic and MACD indicators, which are in the same CLASS of Oscillator indicators, is for the instances when bullish or bearish PRICE/RSI DIVERGENCES show up by using the RSI specifically, which can signal significant trend reversals ahead.

I'll have more to say on this in subsequent Trader Corner's articles that explore the Stochastics, RSI and MACD indicators. I'll continue on this topic in my next (Wed.) Trader's Corner article. Just remember what an 'oscillating' fan is: one that is set to move back and forth between two fixed/extreme points.

This Wed. Trader's Corner article serves as an adjunct to my weekend 'Index Trader' column. In my Trader's Corner article I can briefly update a technical picture of the market as of midweek, and then use recent chart/indicator patterns to more fully explain their relevance to trading decisions in general.

More on my specific predictions, support and resistance, etc. is found in my weekend Index Trader column, available on the Option Investor.com WEB site (not part of the e-mailed weekend OI Daily). You will see a web LINK to the Index Trader at the top of your weekend Option Investor Daily e-mail. My most recent (Sat, 2/4) Index Trader can also be viewed online by clicking here.

Please send any technical and Index-related questions for possible use in my next Trader's Corner article to Click here to email Leigh Stevens Support [at] OptionInvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **

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