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Technical Analysis: Identifying Trend Reversals

One of the expressions often heard after a substantial decline in equity values is "the market is oversold". But, what is it that makes the stock market or a particular issue oversold and what chart indicators can be used to identify this condition. Better yet, how does a trader determine when a stock is beginning to rebound from an oversold condition as opposed to simply experiencing a "whip-saw" in reaction to a decrease in selling pressure?

In the broader equity markets, the condition of being overbought or oversold is generally based on the number of stocks advancing or declining. When an unusually high number of issues have advanced, the stock market is said to be "overbought." In contrast, when an excessive number of issues have declined, it is said to be "oversold." Once the market has reached an overbought condition, that's generally an indication a bullish mentality has overwhelmed investors and it's time to start taking profits on long positions. In contrast, when the major indices appear to have declined to a relatively low point in the cycle and the technical indicators suggest the market is oversold, adept investors will usually start buying stocks as the risk of further downside activity is comparatively low.

Indicators that signal extremes in price activity are universally popular as technical analysis tools. However, investors should realize that overbought and oversold indicators only provide a method for determining when a market is approaching historical excesses - they do not always imply the market is at a turning point merely because it has moved beyond a specific level. Those who are successful with this type of analysis understand the condition of overbought or oversold must only be indicated when the issue reaches an excessive state; one which seldom occurs from a historical perspective. Not surprisingly, traders that apply relatively lax boundaries when searching for extreme conditions are seldom able to correctly identify the few occasions when the gauges are truly extended beyond the norm. In addition, using these types of indicators to initiate trades can create a problem for individuals who do not employ other forms of analysis to confirm a particular character or condition. With literally hundreds of different price patterns and indicators, there is simply no reason to rely exclusively on a particular technique to generate effective entry and exit transactions.


Relative Strength Indicator (RSI)

The first step in identifying reversals is to use a reliable indicator that works well with momentum-based technical analysis. One of the most common tools for charting overbought and oversold conditions is the Relative Strength Indicator or RSI. This measure of price momentum was developed by J. Welles Wilder in 1978 and is frequently included in the "oscillators" group because it varies between fixed upper and lower boundaries. The theory behind the RSI is based on the fact that a stock, when advancing, will tend to close nearer to the high of the day than the low (and vice-versa for declining issues). The indicator compares the price performance of a stock to itself, rather than to a stock market index or another stock, thus it should not be confused with other relative strength gauges. The RSI oscillator is indexed from 0 to 100 and is most useful in a well-defined trading channel as trending prices tend to distort overbought and oversold signals. Using the basic values, an oversold signal occurs when the oscillator is at 30 or less and an overbought condition is indicated when the RSI value is 70 or greater. An example is illustrated below:

Experienced chartists also look for divergences between price and the RSI to identify possible changes in the primary trend. For instance, if the stock is making new highs while the RSI fails to surpass its previous high, this is an indication of an impending reversal. When the RSI then turns down and falls below its most recent nadir, an impending reversal is confirmed.


Stochastic Oscillators

Another popular overbought/oversold indicator is the stochastic oscillator. The stochastic oscillator compares the current stock price to its price range over a specifically identified period of time. This success of this method is based on the concept that in an upward trending market, stocks tend to close near their highs and in a downward trending market, stocks tend to close near their lows. It follows that, as an upward trend erodes, stocks close further away from the highs and vice versa. The stochastic indicator attempts to reveal when prices start to group around their lows in a bullish market and just the opposite in a down-trending market. The theory is these conditions may indicate a trend reversal is about to occur.

The stochastic indicator is plotted as two lines on a chart with values ranging from 0 to 100. They are the %D line and %K line, with the %D line considered the more significant of the two. Readings above 80 indicate that the price is probably closing near its high and likewise, readings below 20 indicate that the price is closing near its low. Ordinarily, the %K line will reverse direction before the %D line but, when the %D line changes direction prior to the %K line, a slow and steady reversal in the stock price is usually indicated. A very powerful move is indicated when the plot approaches 0 and 100. When the stochastic nears these extremes following a pullback in price, a good entry point is generally indicated. Many times, when the %K or %D lines begin to flatten out, this is an indication the trend will reverse during the next trading range. Here's a chart that shows the relationship between stochastics and weekly price activity (note the periods when an overbought/oversold condition is indicated):

As you might expect, one of the simplest applications of stochastics is to identify the divergence between price and momentum. This situation occurs when the stock price is making higher highs while the stochastic oscillator is making lower lows (or the opposite). Remember, the purpose of an oscillator is to alert traders to a reversal; a potential failed rally or the possible conclusion of a sell-off. If the stochastic indicator fails to confirm a stock's new high, traders should consider waiting for %K to cross below %D and to drop below 70 before considering an exit. When the stochastic indicator fails to achieve a new low along with the share value, investors should generally wait for %K to cross above %D and to climb above 30 before entering a new (bullish) position. In any case, a bullish or bearish stochastic divergence should always be validated by the market's price action. When used correctly, the stochastic oscillator can often demonstrate a change in price before the reversal actually occurs and that can be very helpful in determining the appropriate time to enter or exit a position.

Technical analysis can play a vital role in helping to identify stocks in the early stages of a character change. Certainly, the study of RSI and stochastic indicators will provide clues as to which issues may become future winners (or quickly turn into losers). At the same time, establishing the correct parameters in which the terms "overbought" and "oversold" apply is an important prerequisite for utilizing momentum-based indicators and despite the frequent reference to these terms, they are valid only in truly exceptional conditions. In fact, definitive buy or sell signals are rarely indicated by oscillators thus additional types of analysis are almost always necessary to accurately forecast the future trend of a particular issue.

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