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Trader's Corner

Trading Range Markets and Overbought/Oversold Extremes

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The S&P segment of the market remains, more or less, in a sideways trend as these indices retreated this week from just over the high end of its multi-month price range - suggesting that buyers and sellers remain pretty much in balance in their control or ability to take the market in a new direction.

The market may be continuing to mark time, ahead of when more influences get known and bring in new buyers or sellers. For example, the concern about the lack of a strong consistent earnings rebound in the tech market and for Nasdaq.

Selling premium as in short options is attractive during these sideways periods. Some would not call recent week's trading in the S&P 500 (SPX) seen below, a TREND at all, but rather the absence of trend. I am in the school that a broad trading range - a sideways move - is a definite trend.

Those of you who have read my recent Index Trader articles on the website - you can click here for the last one -will know that a sideways trend can make "moving average envelopes" a helpful indicator - this indicator is seen on the chart below.

The centered (magenta) line is the 21-day moving average; the red line above equal to 103% of the moving average; the dark green line below is equal to 97.5% of the moving average value for that day - another way of saying this is that the lower line is set to float 2.5% below the centered line. For the S&P 500 (SPX) and S&P 100 (OEX), the percent values, up and down, are usually around 3% and 90% of trading will tend to be at prices that are within 3% of SPX or OEX's 21-day closing average.

Two Technical Analysis Concepts

  1. If an Index or stock penetrates the upper or lower end of a price range that is some weeks old and then reverses to back within the price range, it's a sell or short signal usually.

This action is also called a "bull trap" reversal - a move to new high followed by a quick and sharp reversal typically. This is often the result of a lot of exiting (buy) stops being hit first as short S&P stock index futures are liquidated. Then, stock prices settle down again.

  1. The 21-day moving average often shows the areas of either support or resistance for the main stock indexes - a trading demarcation so to speak. Trading at prices above the average tends to have bullish implications. Conversely, trading below the average tends to suggest a further down-trending period ahead.

Over the next couple of days (Thursday/Friday) we'll see if SPX closes under the average. If so, the SPX Index may be headed toward the low end of its trading range or toward the lower parallel level (dashed blue) line - this would also be back down toward the lower dark-green envelope line.


 

Corrections can be in "price" or "time" - or some of each. A PRICE correction is when a stock index, or a stock, retraces some portion of the prior move but less than two thirds

...OR prices mark time and go sideways (S&P) which is a TIME correction or a just plain "consolidation". A consolidation is most often a sideways trend followed by a resumption of the prior trend. However, the duration of the resulting sideways trend or trading range can be months long. IF the low end of the price range gives way, the consolidation, sideways trend and trading range was part of a lengthy top formation.

In this Trader's Corner, I'm suggesting to watch how Index price action plays out versus the 21-day moving average. A close below this average by week's end, suggests further downside or selling pressures ahead. Conversely, ability to hold hear the average, then rally some, is suggesting potential for a re-test of recent highs - right now that looks less likely to me.

Also, it appeared that this week's retreat from a brief journey to new highs in NYSE-related indexes (e.g., SPX, OEX and DJX) also was an outcome of the NYSE market being overbought. This is well demonstrated by the index leading the market, the Dow 30 Industrials (INDU). Also, by use of the stochastic indicator set at 21 (length = 21) and used on a daily chart -

INDU reached resistance implied by the upper trendline at the red down arrow AND the Stochastic model hit upper extremes for a second time recently. A second, more rarely, a THIRD time, that this indicator is up as high as the top most red zone, will tend to precede another decline of tradable dimensions and potential.


 

When you hear someone say the market is overbought or oversold, you should also assess what time frame they are talking about - assuming they KNOW what they are talking about and not just repeating something that they have heard.

Here I am talking about a case of the Dow 30 especially to have gotten overbought in terms of the potential for a fall over the next 2-3 weeks - the time horizon in fact that we option traders are often most concerned with.

In a strong bull market, which we no longer seem to be in, or in a powerful bear trend, overbought/oversold concepts are not so helpful as trading guides. In a strong up trend, such indicators will tend to go up and keep going up, staying at "overbought" levels for long periods.

The same is true in a bear market, and we can find plenty of examples prior to 2003 - the conventional technical indicators that attempt to define the relative concepts overbought and oversold are going to say that the market is oversold, and oversold and again, oversold!

In a TRADING RANGE market however, use of overbought/oversold readings can be quite helpful! Especially when an extreme in these indicators is accompanied by prices being at the high or low end of a trading range of some weeks; e.g., the recent Dow STOCHASTIC overbought extreme. This confluence could have alerted us to the high potential for a downside reversal - a wonderful help in formulating a strategy to exit calls (and possibly to buy puts) when the rally into new high ground started to fail.

Some Basics On Overbought/Oversold

An index, or an individual stock, is commonly thought to be overbought or oversold when prices have an advance or decline of a degree that is greater than what is normal or usual relative to its past price behavior for a certain time frame and condition.

Take, for example, the case of a stock that for five months, or 5 years even, has never traded at a price that was greater than 10% of its closing average for the prior 200 days. Then comes a period when there is such a steep advance that the stock reaches a price that puts it 20-25% above this same average - this stock may be considered to be "overbought". Overbought here implies simply that any surge in buying well in excess of what is usual on an historical basis, also creates a likelihood that the stock price will correct.

Another example of an overbought condition might make an assumption about a stock INDEX that has closed higher for 10 days straight - if this price behavior is "over" or beyond what is usual for this index, the assumption is that prices are vulnerable to snapping back - a rubber band analogy is a good one, as market valuations get stretched, so to speak, but then tend to also come back to a mean or an average.

The concept of overbought and oversold refer to rallies or declines that are steeper than usual, but the degree of this can vary a good deal in terms - there is no precise, objective or agreed upon measurement. I tend to talk about the 2-3 trading horizon.

Note-
To Option Investor Subscribers - Please send any technical and Index-related questions for possible use in my next Trader's Corner article to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

Good Trading Success!!

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