Overbought and Oversold

Testimonials

Posted on Thursday, May 11, 2017 at 3:22 PM

The goal for most traders is to catch a trend early and ride it to the end. To accomplish that requires incredible timing on both entry and exit. This article will focus on recognizing when a market has moved too far too fast and is therefore likely to stall out or reverse direction.

Markets often telegraph an end of a trend by simply going through a period consolidation. Markets were created to facilitate trade. When a market moves in a direction and the day ranges and volume decrease, it is not facilitating trade. Subsequently, a reversal often occurs.

Another type of reversal comes when a market is over extended. This is commonly known as overbought or oversold. Many analysts use technical indicators to track the speed of a move, the most popular are RSI and Stochastics. When either of these indicators get above 80, a market is thought to be overbought.  On the other hand, a reading below 20 signals an oversold situation. One problem with these indicators is that a market may hang around that 20 or 80 level for weeks. This makes timing a reversal difficult.

A trader can become more skilled at picking tops and bottoms by becoming familiar with market dimensions, mainly average ranges over a few time frames. If we track benchmarks regarding range we can define when odds have shifted to favor an end or reversal of trend.

For example, if a day range spans more than 150% of the average in a 24-hour period, it is considered overdone, thus odds favor a rest period or reversal. Currently, an average day range for S&P futures is 16 points. If the range during a day session extends 24 points, probability favors a reversal. Such large ranges during a trend are often called exhaustion moves.

In the crude oil chart below there is a bracket that spans the length of an average week. For a longer-term barometer refer to the average week range. In this example, oil surpassed an average week range in a 48-hour period.  Generally, if a market moves the length of an average week in just 2 days, it is considered overdone and due for a reversal or period of consolidation.

 When riding a trade, it is difficult to time when and where to take profit. A severely overbought/oversold signal can help with picking off extreme high and lows for both entry and exit trades.

John Seguin 

Senior Futures Instructor

Market Taker Mentoring

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