Countertrend strategies are a great complement to trend following or momentum strategies. Counter-trend strategies utilize technical indicators such as the Stochastic Oscillator to determine when a security is overbought or oversold. We believe overbought conditions are a natural byproduct of positive momentum, but it will eventually take its toll. Instead, we believe that oversold conditions are a byproduct of negative momentum, but that it ultimately provides opportunity. The Stochastic Oscillator measures the closing price levels relative to a high and low range within a specific period. The default is often 14 periods, but we prefer to use 12 periods because we find that the frequency of the signal matches our method very well. The Stochastic Oscillator consists of two lines: %K, representing the current price relative to the range, and %D, the smoothed average of %K. The indicator oscillates between 0 and 100%. When a security is below 20%, it is considered oversold, and when it is above 80%, it is considered overbought. When a crossover occurs, the stochastic oscillator produces a useful signal. For example, on the monthly chart of the iShares Russell 2000 ETF (IWM), long-term overbought conditions have persisted for nearly a year (November 2020-October 2021). When %K (blue line) crossed back below 80% in November 2021, a “sell” signal was generated. Past sell signals are represented by red arrows on the chart, and opposite “buy” signals are represented by green arrows. In our work, a buy signal requires the %K line to rise above 20%. A common scenario is what we call an “oversold retest,” where the Stochastic rises oversold by more than 20%, briefly dips, and then zigzags higher again. This happens often during the base phase, and this was the case for IWM in the second half of 2022. On the weekly chart, given the timeliness of buy and sell signals from mid-2022 to late 2023, it is clear that the Stochastic Oscillator is more effective as a standalone indicator in a trading range environment. The daily bar chart shows the short-term time frame. Another thing to consider when using the stochastic indicator is the current trend. When a buy or sell signal occurs in the direction of the current trend, it usually has a greater chance of working. Recently, the daily stochastics turned oversold to the upside above the IWM's rising 200-day moving average, leading to a rebound. At Fairlead Strategies, we consider directional bias on all three time frames. Longer term, IWM had a monthly overbought downturn in June, but since it has only been below 80% for a month (i.e. an unconfirmed signal), this has yet to be confirmed, so we defer to positive long-term momentum. In the medium term, the outlook has weakened given the recent overbought sluggish stochastic indicator. IWM has more room to rebound in the short term as the stochastics move higher, with room to move into overbought territory. In summary, the Stochastic Oscillator can help traders determine when a trend is overdoing its upward or downward trend. It is best used in conjunction with other technical tools such as support and resistance, momentum indicators, and market internal indicators. —Katie Stockton and Will Tamplin Get free access to Fairlead Strategies research here. Disclosure: (None) All opinions expressed by CNBC Pro contributors are theirs alone and do not reflect the opinions of CNBC, NBC UNIVERSAL, its parent company or affiliates, and may have been previously published by them on television, radio, the Internet or spread on other media. The above is subject to our Terms and Conditions and Privacy Policy. This content is for informational purposes only and does not constitute financial, investment, tax or legal advice or a recommendation to purchase any security or other financial asset. The content is general in nature and does not reflect any individual's unique personal circumstances. The above may not apply to your particular situation. Before making any financial decisions, you should strongly consider seeking advice from your own financial or investment advisor. Click here to view the complete disclaimer.