Reversals and Overbought/Oversold Markets

Over the past two weeks we have seen far above average vertical moves in stocks, bonds, forex, precious metals and crude oil. So, to be pertinent, I thought it best to introduce several ways to identify change in trend after a market has moved too far, too fast. This is otherwise known as reaching overbought/oversold (OB/OS) status.   

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. Of the 2 indicators Stochastics generate better reversal signals, while RSI is a strength of trend indicator.

Fading Momentum

In the trading world momentum is velocity times volume. Markets were created to facilitate trade. Thus, when volume and ranges decrease, trends often end or reverse. When a market reaches OB/OS status and volume begins to fade, Stochastics become a more effective indicator of change. Stochastics are generally better for calling tops and bottoms.

Aberrant Deviations

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. Aberrant deviations are perhaps the best way to measure overbought/oversold status.

First, we must define benchmarks using market-generated information. There are roughly 20 trading days each month. Thus, I frequently use a 20-day average true range (ATR) for a short-term benchmark. For a mid-term standard I use a 13-week ATR (13 weeks in a quarter). 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 signals are not reliable 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 20-day ATR, the move is considered aberrant or OB/OS.
  • If the range reaches the length of the 13-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 ideal setups. Countertrade or mean reversion strategies work best after an atypical vertical 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.

ATRs Are a Must

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 gone too far, too fast. 

John Seguin, Market Taker Mentoring

Trader Education