the hAnDbook of technIcAl AnAlySISextreme levels that the stochastics overextension levels are behaviorally tuned.
A higher frequency of alternation between overbought and oversold signals is
also an indication of potentially greater short term participation in the markets.
Note that Silver reversed at the Fibonacci retracement levels while the oscillator
was at overbought.
It should be noted that the %K formula represent a normalizing process. It
is in fact identical to the RSI normalizing process. To normalize data means to
bind it with a range of values, with an upper and lower limit. One disadvantage
of normalization in the stochastic oscillator is that it tends produce erratic swings
between the overbought and oversold levels especially when the price range as-
sociated with the %K lookback period is very narrow.relative strength Index (rsI)
Created by Welles Wilder, the RSI tracks the stock’s underlying strength in terms
of its average gain and loss of over the last n periods. Let the average gains over
the last n periods be G and the average loss over the last n periods be L. Relative
strength, RS, is defined as RS = |G/L|.RSI=−+100 100 1[ /( GL/ )]
Re-arranging weget RSI, , =×+ 100 ( /(GGL))This is similar to the stochastic normalization process where the maximum
value in the numerator will always be equal to or less than the value in the denom-
inator. Welles Wilder used a 14‐period lookback and smoothed the RSI data using
the Wilder’s averaging, which is a form of exponential moving average. The RSI
is less volatile than the stochastic action and may be a good replacement for the
stochastic in volatile markets. The RSI oscillator may be analyzed for buy (bull-
ish) and sell (bearish) signals using any of the eight forms of oscillator analysis
described in a previous section. Overbought and oversold levels are defaulted at
70 percent and 30 percent, respectively. Many practitioners regard a confluence of
buy and sell signals occurring on both the stochastic and RSI oscillators as more
reliable. One approach is to first look for a dip below the oversold level on both
these oscillators. Once the readings rise back above the oversold level on both os-
cillators, a buy signal is issued. The reverse is true for sell signals. In Figure 8.24,
we observe a buy signal as both oscillator readings rose above the oversold level
on the daily chart of Starbucks Corp. The trigger for entry would normally be the
high of the candlestick or bar associated with the observed buy signal.8.7 Overlay Indicators
As we have already seen, overlays are classified into four categories, namely:■ (^) Numerically based overlays
■ (^) Geometrically based overlays