I often hear traders throwing around terms like an "overbought" market that is due to fall or an "oversold" stock that has to bounce back sometime. I've learned through experience that the best uptrends stay overbought and the nastiest downtrends stay oversold. In fact, that's where the most potent leg of a trend tends to occur.

When Apple Computer (AAPL) started to break out on the success of its iPod music player on September 3, the market was still in a bit of a pre-election funk. Even though most stocks underwent a correction in mid-to-late October before the surge in November, but Apple made continued upside progress. This persistent price strength was first signaled when Apple shares went above the 80% mark on the 21-day %K Stochastics on September 3 with a high that day at 35.92 and two trading days later closed above 35.92 to confirm the uptrend was unusual and likely to keep heading higher. Many pointed to evidence of overbought indicators like Stochastics as evidence of a likely decline to come.  Never mind that they were fighting the breakout above my Acceleration Bands (20-day Acceleration Bands in red on lower half of chart, and 80-day Acceleration Bands in green - also I've plotted the 20-day Bollinger Bands in magenta to show how they differ from the red Acceleration Bands).

I've found that when Stochastics go overbought above the 80% threshold, as they did for AAPL the first week of September, and then the price action confirms the breakout with a subsequent close above the high on the day of the first overbought reading over 80%, this is often where the trend keeps heating up. I've marked that point of the first overbought reading on Stochastics with a pink vertical line. My Stochastics indicator is different than most, in that it uses exponential smoothing with a longer 21-day %K reading and a 10-day %D input. Here I'm only focused on %K, plotted in red on the upper half of the chart. The surge above 80% was followed two weeks later by a close over that week's high, to confirm the ongoing uptrend. Only when the %K line crosses under 80% do we set a new closing stop if we see a subsequent close below the low on the day the indicator crosses under 80% for %K - then I consider the uptrend over and exit the stock. (For bear trades, flip the rationale when we cross below the 20% "oversold" threshold). AAPL recently reached a recent low %K reading of 77% this past week when the stock had a brief pullback with a price low that day of 62.56. Note that the next two days the stock tested intraday under that new end-of-day stop, but it reversed back up by the close each time to finish over 62.56 and then popped still higher on Friday. This method allows you to clearly define the entry point and new stops as each new inflection point is reached.

Any trader who is shorting AAPL back in early-September around 36 on the first cross into "overbought" territory was clearly asking for trouble.  The lesson here is that %K readings stuck between 20 and 80 tend to characterize range-bound markets, while readings over 80 often show potent uptrends and readings below 20 can often signify further declines ahead. Don't get caught trying to apply an oscillator like Stochastics or RSI to a strongly trending market. This modified Stochastics approach, which I call Stochastics Confirmation (because it requires price confirmation once the overbought/oversold area is reached) can allow you to identify new big trends as they are just starting to accelerate.

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Price Headley is the founder and chief analyst of BigTrends.com.