In day 8 of the 9 days to master part-time swing trading challenge as I show you how use the stochastic indicator to trade overbought and oversold conditions in stocks and the overall market.
The Concept: Overbought and Oversold
As swing traders, our favorite stocks and market are those that show strong momentum (rate of change in one direction).
However, in momentum markets there usually comes a point where the momentum becomes so strong and outside of the normal trading range that the rate of change in price action becomes unsustainable.
This is known as an overbought or oversold condition.
An overbought or oversold condition is where price is likely to consolidate or reverse.
However, there is no guarantee that this will happen.
In fact, in some supercharged markets, overbought or oversold levels can persist for a long time without a reversal or consolidation. We will talk about in later challenges, but for now let’s work on identifying overbought and oversold levels.
As you develop as a trader, you will be able to identify overbought and oversold conditions without any indicators, just by analyzing the price action. That being said, the best objective way to analyze overbought and oversold levels is to use the stochastic indicator.
The stochastic indicator measures the rate of change, or acceleration, of a stock.
That’s the extent of what we need to know.
While there is a formula for it’s calculation, all we need to know to trade effectively is how to use it (you don’t make any money by knowing the formula and plugging in the numbers!).
Here are the keys to using the indicator
- Set the indicator at 5,3,3
- Classify a stock or market as overbought at 70+
- Classify a stock or market as extremely overbought at 85+
- Classify a stock or market as oversold at 30 or less
- Classify a stock or market as extremely oversold at 15 or less.
- If the indicators reverses sharply, expect reversal
- If price action stays in the overbought or oversold zone, expect trend to continue.
Remember, we are not going over any setups today.
Instead we are learning how to use the indicator.
Keep in mind that these classification are just a guide, and not actual buy or sell signals. Buy and sell signals take into account many factors along with these levels.
Watch today’s video for a more in depth analysis with charts on how and why we use stochastics.
The Day 8 Exercise
- Pull up the charts for SPY, QQQ, NFLX, AMAZN, FB and GOOGL.
- Identify every overbought and oversold condition over the past 2 years.
- Note where they because overbought/oversold and where levels became extreme.
- Study price action and patterns after these levels were hit.
Day 1: Getting Started
Day 2: Analyze the Market
Day 3: How to Use Moving Averages
Day 7: The Reward to Risk Ratio
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