Using indicators such as MACD, RSI or Stochastic, you are using a method of oscillator divergence. Divergence occurs when momentum is slowing and is likely to reverse. The concept is to find inconsistencies between the price and the oscillator. The price changes in real time but the oscillator is based on the momentum of the price and using historical figures. This means that the oscillator is a lagging indicator.
As in the above example, you can see a typical problem that you will encounter when trading divergences. The first buy signal in the middle occurs when the oscillator appears to have reached the trough. As you can see this is actually a false signal and would not have been the optimal time to enter the position.
You have to be wary of these setups, as the textbook examples you see are much harder to spot in real-time. In real-time, there is no way of knowing if the current low is just an inflection point as the above example or a true low as the top example. Because of this below are a couple of methods for helping to detect the false positives and weed them out.
You can increase the size of the sample area of the detector. This will decrease the cases where there is not a high enough extreme on the overbought or oversold levels. This will reduce the number of false positives but it will also decrease the number of trades you enter so this needs to be weighed up.
You can increase the amount of confirmation bars you use to confirm the low. If in the above example I needed it to trade 7 bars at the low, then it would not have triggered the buy signal as the oscillator falls again before it is confirmed.
For this strategy to work you will always need to match tops with tops and bottoms with bottoms. In the above example, you can see the bottoms are in line on the price and also the MACD.
Issue with Method
As with any technical analysis, there can be false signals and these must be expected. Due to this, you will want to use this in conjunction with another indicator to leave you only entering the highest probability trades and miss out the ones with low or marginal outcomes.
When using this strategy, you will take your directions from the oscillator and it will help to dictate what dictate which direction your trade should be placed.
The example above shows the second rule in place as the market shows that is it overbought looking at the MACD, and the MACD is falling. At the same time, the price is still rising/ hitting the same level. When the price goes level or above the first high price level, then you will want to sell.