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. Read on below for a current example.

When Activision (ATVI) started to break out after its earnings in early November, this persistent price strength caused a reading above the 80% mark on the 21-day %K Stochastics on November 5 with a high that day at 15.80 and four trading days later closed above that high to finish at 15.98 and 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).

I've found that when Stochastics go overbought above the 80% threshold, as they did for ATVI the second week of November, 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 also marked the first test back under 80% in the %K 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). ATVI recently came out with earnings again and we decided to book our profits in the stock, notching a 189% gain on the total position. 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 ATVI back in early-November around 16 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 ia reached) can allow you to identify new big trends as they are just starting to accelerate.

Click here to view the daily chart of Activision (ATVI). A new window will open.

Price Headley is the founder and chief analyst of BigTrends.com, which provides daily stock and options recommendations and education.