Given the recent jump in volatility for interest rates, equity and energy markets, I figured it would be appropriate to introduce a few of my preferred velocity indicators.
Traders endeavor to enter a trend early and exit that position at the peak of a rally or the trough of a bearish run. Some trends end slowly after shifting to neutral while others end abruptly after moving too far, too fast. Otherwise known as reaching overbought/oversold (OB/OS) status. Therefore, a trader should have an indicator that reveals when the pace of a trend is well above average. Above average moves typically lead to consolidation phases where credit spreads tend to perform well.
Stochastics and Momentum
Stochastics are frequently used to gauge whether a market is overbought or oversold by a reading above 80 or below 20 respectively. However, these indicators are often deceiving. Markets may have a reading over 80 or under 20 for weeks. Therefore, a Stochastic reading may be an unreliable gauge for identifying trend reversals. If prices are moving higher and the Stochastic is too, the trend is not ready to reverse. The opposite is true when prices are moving lower. However, if the Stochastic reading has turned lower when prices are rising it is a signal that momentum is not confirmed. Therefore, odds favor a trend reversal. If the price is moving lower and the Stochastic is not, a rebound frequently follows. This phenomenon is called divergence.
Fading Momentum
Markets are created to facilitate trade. Thus, when volume dissipates and day ranges decrease during a trend, it indicates a loss of momentum, increasing the odds for a reversal of direction. When a market reaches OB/OS (overbought/oversold) status and volume dissipates, Stochastics become more effective. Stochastics are generally better for picking tops and bottoms, while RSI is better used as a strength of trend indicator.
Aberrant Deviations
Markets move from balance to imbalance and back to balance. They often telegraph an end of a trend by simply entering a period of congestion. Another type of reversal comes when a market is overextended. Aberrant deviations are perhaps the best way to measure overbought/oversold status.
The first step is to define benchmarks using average range. I employ a 14-day average true range (ATR) for a short-term benchmark and a 9-week ATR for a mid-term standard. I also use another ATR that is an average of 7 months. I use multiples of these average ranges to determine if a market has moved too far, too fast. These benchmarks are used to measure aberrant deviations from the standard. It should be noted that overbought/oversold countertrend signals are not reliable indicators alone. They are more efficient when the OB/OS signal is realized and the market is testing previous consolidation zones.
OB/OS Deviations
- If a day range reaches 175% of the 14-day ATR, the move is deemed OB/OS.
- If the range reaches the length of the 9-week ATR in a 48-hour period, it is thought to be OB/OS.
- Over a 5–6-day span, a range that extends the length of the 7-month ATR it is deemed overbought/oversold.
If any of these deviations occur and volume begins to wane, odds improve for a pause or reversal of trend. If you prefer to write options to collect premium, these may be ideal setups. Countertrade or mean reversion strategies work best after an atypical move. This formula works for longer time frames. Calculate an average week range. If a market moves that length in a 48-hour period, chances are it will stall or reverse.
Final Thoughts
Whether you are a day or swing trader or a long-term investor it is imperative to know the average range of your preferred trade duration. ATRs may be used for setting profit targets as well as assessing if a market has gone too far, too fast.
John Seguin
Senior Technical Analyst
Market Taker Mentoring
