The trading activity of this crowd usually stays within fairly narrow boundaries. But imbalances develop over time and force one side to pull the trigger, sometimes prematurely. This "uses up" that side of the market and awakens price mechanics that favor the other side.

Bollinger Bands offer an effective tool for measuring overbought/oversold conditions. Notice how Nvidia (NVDA:Nasdaq - news - commentary - research - analysis) triggers a short-term reversal each time price bars thrust outside the extremes of the 20-day Bollinger Bands. These outer bands tell swing traders to expect a reversal before real evidence appears on the price chart. This allows them to take high-profit exits while the rest of the crowd is caught in the moment.

It's important to note that overbought/oversold markets are relative to a trader's time frame. In the NVDA chart, some reversals were simple pullbacks in the underlying trend, while others represented major market turns. It is vitally important for traders to define their holding period before reacting to short-term price swings. Major profits will be lost by planning the trade in one time frame but executing it in another.

 

Stochastics represents the classic overbought/oversold oscillator. Unfortunately, most traders don't understand how to interpret the information it provides. The worst thing you can do is jump ship just because stochastics hits a high or low extreme. Most swing-trading profits are booked in the early stages of overbought or oversold markets. Of course, that's where most of the risk is as well.

Use simple double-top or double-bottom patterns to pinpoint reversals driven by overbought or oversold conditions. The best signals come when stochastics makes a lower high (or higher low) and expands in the opposite direction. This type of pattern will often complete ahead of price change, and should be acted upon without waiting for further confirmation.

 

A single price bar can change everything. Stocks trade with an average high-low range through most market conditions