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Overbought/Oversold Indicators - Stochastics & Williams' %R

Please note that we have used historical data. These examples are for educational purposes only.

The concept of overbought and oversold is an important one if you want to learn to time the markets accurately. The notion is that the price quickly becomes imbalanced if it moves too quickly or too far in one direction or the other.

Larry Williams, a well-respected commodity trader, once wrote, "For my money, the technical theory of most value and validity is the concept of overbought/oversold."

The Stochastics indicator is a versatile tool for tracking the overbought/oversold markets and one of the best indicators for catching price reversals (particularly in combination with another indicator such as MACD.

Larry Williams developed a variation of the Stochastics Indicator which he called the % R. He originally developed it for trading commodities but it has since become a favorite tool for many stock traders as well. In my experience, the Williams %R indicator has an amazing ability to catch each and every meaningful reversal point, if properly applied!

CURRENT TRENDS - Learning from the S&P using Williams %R

The S&P 500 index, like most of the other major indices, has been in a volatile sideways trading range for a year now. Choppy markets with big swings are usually difficult ones to trade because entry and exit points are hard to identify. A good solution? - Stochastics and Williams %R. These two indicators will provide you with reliable signals even in a choppy market. Let's take a look at the S&P 500 using Williams %R to shed some light...

Here's a chart showing the market action in the S&P 500 over the last year. I've plotted a few simple trend lines to highlight the mid- to long-term trends over that period. You can see that the overall trend has been upwards and sideways, with lots of dips and bumps along the way. The 20 and 50-day Moving Averages are also plotted.

At first these charts may appear almost overwhelming. There's no clear pattern developing, the markets are whip lashing all over the place.

Pull up a stump and take a closer look at the Williams %R indicator. Williams originally wrote, "...readings below 95% give a buy indication - during bull markets. A reading above 10% gives a sell signal during bear markets." To this I would add - wait for the %R to hit 99-100% (the bottom of the chart) and then cross back up through the 95% level. This gives you an almost a sure signal that the market will reverse! It could be a short-term reversal... but it will reverse. (You can see that this would be particularly well-suited to the short-term or day-trading approach.) The reversal almost never fails to materialize - and I'm not kidding.

In the chart above, you can see that Williams %R has offered 5 clear buy signals in the past year based on this system. However, I must add that Williams was also quite clear that you use the buy signal in a bull market only... He wrote, "the %R index will not work if you insist on acting on the buy signals during a bear market." Base on the chart above, I would say that the S&P was in a bull market until it broke down through the long-term trendline shown in red in September.

That would make our most recent buy signal somewhat dubious - and you can see that the market was extremely volatile and it would have been difficult to trade even on a very quick-footed, short-term basis. In my ChartFilter.com report on Williams %R I've written that it is not very useful in a sideways market. Before using any indicator, therefore, I recommend drawing the trendlines and establishing the long-term, mid-term and short-term trends.

To my mind, Williams %R is worth its weight in gold in volatile markets. Check it out with some of the other indices and markets you are following.

TIPS & TECHNIQUES - Using Stochastics & Williams %R

Stochastics and Williams %R are two versatile momentum indicators. They are very useful for catching short-term market reversals, making them particularly well-suited to the active trader. They can act as leading indicators, warning of strength or weakness in the market, often ahead of the actual turning point.

There's much more to the application and interpretation of these indicators than I have room for in this short newsletter. With Stochastics, for example, two lines are normally plotted and additional signals are generated when they cross one another. Further signals are generated by divergence from the price activity and underlying patterns in the Stochastics line.

PROFIT POTENTIAL - Sanmina Corporation (Nasdaq: SANM)

Sanmina Corporation (SANM), an electronic manufacturing services company, has been receiving some favourable press recently. For example, here's an excerpt from a recent article:

Fool.com -- Sanmina put up some stellar numbers over the last 12 months, including 64% revenue growth and 63% EPS growth. Fourth quarter 2000 revenues were greater than all of 1998 revenues, and margins have remained steady.

Current consensus estimates for fiscal 2001 for Sanmina are $2.57 per share. That is greater than 100% EPS growth based on actual diluted 1999 EPS of $1.24, and 55% EPS growth based on 1999 diluted EPS excluding one-time charges.

Sanmina's future is all about demand. As long as global demand for better, stronger, and faster electronic devices holds up, Sanmina's prospects look strong.

Based on this, we should take a look at the chart and see if the technical side can shed any further light on this potential opportunity. Let's see what we can determine from the Stochastics and William %R indicators in particular...

Here's the price chart for SANM over the past year, along with the 20- and 50-day MAs. I've also added the Stochastics, Williams %R and MACD charts below.

When using Stochastics, the 20% and 80% levels are usually interpreted as the overbought/oversold thresholds. The buy signal occurs when the Stochastics lines cross down through the 20% level, form a bottom, and then cross back up through the 20% level. The sell signal is the opposite, using the 80% level.

The problem with this approach, to my mind, is that the Stochastics is extremely sensitive and provides too many choppy signals (for my personal style, that is). Now, this is fine if you like to trade very actively. You can see, however, that signals based on the Williams %R 95% level are more selective and potentially more profitable. In the past year, we would have had 13 buy signals generated by Stochastics - and most of them without much of a move to follow. Williams %R, on the other hand, has offered one strong buy signal -- in mid-April - at exactly the low point in the market. (There were a couple of other buy signals earlier in Dec 99/Jan 2000, but they never reached the 99-100% level that I advocate.)

Notice what the Stochastics is currently showing us? It has broken down through the 20% level, formed a very low, sharp bottom, and is poised to penetrate above 20%. This would be a Stochastics buy signal. What I would recommend, however, is waiting to see what Williams %R does. If it drops below 95%, hits 99-100%, and then sharply penetrates up through the 95% level you would have a very strong buy signal confirming the Stochastics signal. Of course, Williams %R may not oblige - but that's the beauty of using two indicators. Williams %R can be very valuable as an effective filter for keeping you out questionable markets.

And remember the idea of using MACD as a complimentary indicator to accompany Stochastics and/or Williams %R. You can see that the recent MACD buy signal was premature on its own... if MACD remains in positive territory, however, and you get a Williams %R buy signal the world could be your oyster! (MACD appears to be indecisive at the moment - so keep an eye on it along with the overbought/oversold indicators).

Putting ChartFilter into Context

ChartFilter is meant to complement your overall trading knowledge and decision-making. This newsletter focuses on applying technical analysis (TA) methods to various markets; but this is not to say that you shouldn't be considering important fundamental criteria, such as EPS or revenue, as well. Think of ChartFilter as your TA assistant; not as your overall trading strategist.