There are a number of technical indicators known as oscillators. They are all interpreted pretty much the same way. We are going to concentrate on the most popular one: stochastics. It’s worth looking at for the same reason the 50- and 200-day moving averages are worth looking at: everyone else is looking at them, too, and you want to see what other people are seeing. Among oscillators, stochastics are the ones most stock chartists are looking at.

The stochastic oscillator is interpreted as a sine-like wave fluctuating from below the 20 level, which marks oversold territory, to above the 80 band, which marks the overbought boundary. The idea behind this is that when the indicator rises above 80, the stock is overbought. (Stocks can stay overbought for long periods of time. In fact, the biggest winners will stay overbought.)

When the oscillator leaves the overbought level and crosses below the 80 threshold, this is the time to sell the stock. On the other end, the reverse is true. When the stock leaves the oversold area and crosses the 20 level, that’s the time to buy. The illustration above demonstrates this perfectly. (But buyer beware: few times in real life does it work so handily.)

               Divergence—My Favorite Technical Indicator

The foregoing technical indicators are popular and, therefore, useful to understand, but I don’t really believe they have any real predictive power. Now I’m going to tell you about an indicator that actually works. This is divergence. Most oscillator indicators just track the direction of the underlying security. If a stock is rising, the oscillator will generally follow suit. When the stock falls in price, the oscillator will fall with it. Divergence is when this connection between the indicator and underlying stock is broken.

Divergence is a move in the price of an asset not confirmed by a comparable move in the applied technical indicator. For example, in the illustration, the price of HL begins a move upward, yet the indicator—LL—is actually moving in a different direction.

Divergence is the most predictive of all the indicators. However, it will be early more often than not. And early can be very painful. An often-repeated saying on Wall Street is “What’s the difference between being early and wrong?”There isn’t one.

That being said, let me show you how I interpret divergence. First of all, I only look at a version of Wilder’s Relative Strength Index when I’m examining divergence. Developed by J. Welles Wilder, the Relative Strength Index (RSI) is a momentum oscillator that measures the speed and change of price movements. Before we get too far into this, let’s rehash the popular version of what this indicator does, because I don’t use it the way most people do.