Oscillators and mean reversion

What an oscillator is

An oscillator is an indicator that swings between fixed limits, usually 0 and 100. Instead of telling you which way the trend points, it tells you how stretched the latest move is. The famous ones:

• RSI (J. Welles Wilder, 1978): compares the size of recent up days with recent down days. The standard look-back is 14 days.
• Stochastic (popularised by George Lane): where today's close sits in the last 14 days' high-low range. %K is the reading, %D its average.
• Williams %R (Larry Williams): the stochastic flipped upside down, from 0 at the top of the range to −100 at the bottom.
• Money Flow Index: an RSI that also weighs volume. More on that in the volume lesson.

Overbought, oversold and divergence

Readings near the top of the range are called overbought (RSI above 70) and near the bottom oversold (below 30). These words describe a stretched move, not a forecast. In a strong trend a stock can stay overbought for weeks while it keeps climbing.

Wilder, Lane and Appel all said their best signal was a divergence: price makes a new high but the indicator doesn't. Divergences are hard to define mechanically, so Be The Puck's versions use the simpler threshold crossings most traders know, and say so on each play page.

Mean reversion

Mean reversion is the opposite bet to trend following: a price that has moved unusually far, unusually fast, tends to snap partway back. Mean-reversion plays buy sharp dips and sell the bounce, often within days.

Larry Connors and Cesar Alvarez added an important filter: only buy dips in stocks above their 200-day average, where the long trend is still up. Their RSI(2) play buys when a 2-day RSI drops below 10 and sells on the first close above the 5-day average; their Double 7s buys a close at a 7-day low and sells a 7-day high. In their tests, stop-losses hurt these short-term strategies, so the published rules don't use them.

The profile is very different from trend following. Across Be The Puck's tests, mean-reversion plays were right on about 53% of their calls, against 30% for trend plays. But each win is small, the plays sit in cash much of the time, and without a stop an unlucky entry can ride a long decline. The RSI(2) play switched a median of 14 times a year per stock, so trading costs and taxes matter a lot.

Counting to exhaustion

Tom DeMark's approach counts closes. Nine in a row below the close four days earlier completes a "buy setup", a sign the selling may be spent; nine above completes a sell setup. His full TD Sequential method goes on to a 13-bar countdown with more conditions. Be The Puck tests the popular nine-count shortcut and labels it that way.