All traders endeavor to catch a trend early and ride it late. To accomplish that requires incredible timing on both entry and exit. Some trends end slowly after shifting to neutral. Others end abruptly after moving too far, too fast, otherwise known as reaching overbought/oversold (OB/OS) status. Lately, volatility has been quite high as there have been big swings in many markets. Getting long when a market is overbought or short when it is oversold usually does not pay. It is known as poor trade location.

RSI and Stochastics

Relative Strength Index (RSI) and Stochastics are frequently used to gauge whether a market is overbought or oversold by a reading of under 20 or over 80. However, these indicators are often deceiving. Markets may have a reading over 80 or under 20 for weeks. Therefore, these are often poor gauges for calling trend reversals. These indicators perform better when they are tied to a momentum indicator.

Fading Momentum

Momentum = velocity x mass. In trade speak, momentum is velocity times volume. Markets were created to facilitate trade. Thus, when volume dies off trends do too. When a market reaches OB/OS status and volume begins to fade, RSI and Stochastics become more effective indicators. Stochastics are generally better for calling tops and bottoms, while RSI is better used as a strength of trend indicator.

Benchmark Ranges

Markets move from balance to imbalance and back to balance. They often telegraph an end of a trend by simply going through a period of consolidation. Another type of reversal comes when a market is overextended. Abnormal deviations are perhaps the best way to measure overbought/oversold status.

First, we must define benchmarks using market-generated information. The default settings for RSI and Stochastics is 14 periods. Thus, I frequently use a 14-day average true range (ATR) for the short-term benchmark. For a mid-term standard I prefer a 9-week ATR. 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 unusual deviations from the standard. It should be noted that overbought/oversold signals are not good enough indicators to just countertrade a trend. They are more efficient when the OB/OS signal is realized and the market is retesting old support or resistance zones.   

OB/OS Deviations

If a day range is 175% of the 14-day ATR, the move is considered aberrant or 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-to-6-day span, a range that extends the length of the 7-month ATR 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 sell options to collect premium, these may be an 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. 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 can be used for setting profit targets as well as assessing if a market has moved too far, too fast. 

John Seguin, Market Taker Mentoring