Using Two Popular Oscillators: Slow Stochastics and Relative Strength

Two of the more popular computer-generated technical indicators are the Slow Stochastics and Relative Strength Index (RSI) oscillators. (An oscillator, defined in market terms, is a technical study that attempts to measure market price momentum - such as a market being overbought or oversold.)

I'll define and briefly discuss these two oscillators, and then I'll tell you how I use them in my market analysis and trading decisions.

Slow Stochastics:

George Lane has been called the father of the stochastic indicator. I met this gentleman a few years ago. He and his wife still attend and participate in trading seminars around the U.S. Lane's basic premise is as follows: During periods of price decreases, daily closes tend to accumulate near the extreme lows of the day. Periods of price increases tend to show closes accumulating near the extreme highs of the day. The stochastic study is an oscillator designed to indicate oversold and overbought market conditions.

Some technical analysts, including me, prefer the slow stochastic rather than the normal stochastic. The slow stochastic is simply the normal stochastic smoothed via a moving average technique. The slow stochastic, like the normal stochastic study, generates two lines. They are %K and %D. The stochastic has overbought and oversold zones. Lane suggests using 80 as the overbought zone and 20 as the oversold zone. Some technicians prefer 75 and 25. I like to use the 80-20 figures.

Lane also contends the most important signal is divergence between %D and the commodity. He explains divergence as the process where the stochastic %D line makes a series of lower highs while the commodity makes a series of higher highs. This signals an overbought market. An oversold market exhibits a series of lower lows while the %D makes a series of higher lows.

When one of the above patterns appears, you should anticipate a market signal. You initiate a market position when the %K crosses the %D from the right-hand side. A right-hand crossover is when the %D has bottomed or topped and is moving higher or lower and the %K crosses the %D line. According to Lane, the most reliable trades occur with divergence and when the %D is between 10 and 15 for a buy signal and between 85 and 90 for a sell signal.

Relative Strength Index:

The Relative Strength Index (RSI ) is a J. Welles Wilder, Jr. trading tool. The main purpose of the study is to measure the market's strength or weakness. A high RSI, above 70, suggests an overbought or weakening bull market. Conversely, a low RSI, below 30, implies an oversold market or dying bear market. While you can use the RSI as an overbought and oversold indicator, it works best when a failure swing occurs between the RSI and market prices. For example, the market makes new highs after a bull market setback, but the RSI fails to exceed its previous highs.

Another use of the RSI is divergence. Market prices continue to move higher/lower while the RSI fails to move higher/lower during the same time period. Divergence may occur in a few trading intervals, but true divergence usually requires a lengthy time frame, perhaps as much as 20 to 60 trading intervals.

Selling when the RSI is above 70 or buying when the RSI is below 30 can be an expensive trading system. A move to those levels is a signal that market conditions are ripe for a market top or bottom. But it does not, in itself, indicate a top or a bottom. A failure swing or divergence accompanies the best trading signals.

The RSI exhibits chart formations as well. Common bar chart formations readily appear on the RSI study. They are trendlines, head and shoulders, and double tops and bottoms. In addition, the study can highlight support and resistance zones.

How I employ Slow Stochastics and the RSI:

First of all, these two oscillators--especially the RSI--tend to be over-used by many traders. As you just read above, some traders use these oscillators to generate buy and sell signals in markets -- and even as an overall trading system. However, I treat the RSI and Slow Stochastics as just a couple more trading tools in my trading toolbox. I use them in certain situations, but only as "secondary" tools. I tend to use most computer-generated technical indicators as secondary tools when I am analyzing a market or considering a trade. My "primary" trading tools include chart patterns, fundamental analysis and trend lines.

Oscillators tend not to work well in markets that are in a strong trend. They can show a market at either an overbought or oversold reading, while the market continues to trend strongly. Another example of oscillators not working well is when a market trades into the upper boundary of a congestion area on the chart and then breaks out on the upside of the congestion area. At that point, it's likely that an oscillator such as the RSI or Slow Stochastics would show the market as being overbought and possibly generate a sell signal - when in fact, the market is just beginning to show its real upside power.

I do look at oscillators when a market has been in a decent trend for a period of time, but not an overly strong trend. I can pretty much tell by looking at a bar chart if a market is "extended" (overbought or oversold), but will employ the RSI or Slow Stochastics to confirm my thinking. I also like to look at the oscillators when a market has been in a longer-term downtrend. If the readings are extreme- - say a reading of 10 or below on Slow Stochastics or RSI- - that is a good signal the market is well oversold and could be due for at least an upside correction. However, I still would not use an oscillator, under this circumstance, to enter a long-side trade in straight futures, as that would be trying to bottom-pick.

These two oscillators are not perfect and are certainly not the "Holy Grail" that some traders continually seek. However, the RSI and Slow Stochastics are useful tools to employ under certain market conditions.

Jim Wyckoff
TradingEducation.com