Oscillators such as RSI, stochastics, Williams %R, etc., are all designed to help people who are trying to pick tops and bottoms. In my opinion, this is a fool's game, and there is no evidence that entry signals based upon oscillators have a reliability much better than chance. In fact, in most cases there is no evidence that the market generally meets the assumptions that many oscillators are making. As a result, I've elected not to give a long discussion on something in which I have little faith.
However, there is a way that you can use an "overbought/ oversold" oscillator-such as Wilder's RSI-to help you trade with narrow stops (see Chapter 9 on protective stops). Here's what you need to do this sort of trading:
1. Wait until the market gives a clear signal of being in a trend. This is a price-based setup.
2. Wait until the market reverses slightly and your oscillator gives a sign that the reaction has probably reached an extreme. This step also is a price-based setup, only it must occur after step 1.
3. Enter the market in the direction of the previous trend when the market gives a signal that it will again move in that direction. An example would be a return of price to the previous high (or low for a short signal) prior to the extreme oscillator signal.
This sort of trading sets up the possibility of a highly reliable trading signal with a very small stop (i.e., the extreme of the reaction). In addition, since the risk of such a trade is quite small, it means that the reward-to-risk ratio of the potential trade could be very high. This is actually an example of a retracement setup as discussed in the last chapter, and it is, in my opinion, the best way to use oscillators.
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