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Overbought/Oversold as Part of Trading Decisions

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I was absent in this space last Wednesday due to technical difficulties. We've heard that before in countless ways, but there's no sinking feeling like the one when your data connection goes down while you are deciding to stay or go in a trade! Someone wrote me about how I apply the concepts of 'overbought' or 'oversold' to making trading decisions; what do I use, how useful are these things in making trading decisions and so on. These 'things' refer to the common technical indicators that measure stock or index 'momentum' and have values between 0 and 100; that is the ones that are so-called 'normalized' indicators, unlike the MACD (pronounced 'mack-dee') which is the Moving Average Convergence Divergence indicator, which does not just oscillate between 0 and 100. RSI, Stochastics and the MACD are in the class of indicators typically called 'oscillators'.

I pay fairly close attention to the main indicators of this type, the Relative Strength Index (RSI) and the Stochastics model (the 'slow' variation). I haven't done an explanation of the best practices or use of these in a while, so will review the basics. If you have other indicators or chart (patterns, trendlines, etc.) questions please e-mail me per the method noted at the bottom of this column.

First, a note on my last article written on the weekend, my Index Trader article, and a brief technical update on the main option-actionable indexes. This recent Index Trader may be looked at when online by clicking here.

A key aspect technically I've been focusing on with the S&P 100 (OEX), is whether the recent rebound was going to carry BEYOND a percentage retracement that would suggest the prior high would get re-tested. Or, whether the retracement amount from low to prior high was going to remain at a 2/3rds or less retracement of the prior decline, which would suggest that this was the high water mark.

On a closing basis, OEX has not been able to climb more than a bit above the 66% retracement. The longer you see this go on, the more likely that the Index (or stock) will start falling again and today was a good example. Today's action in fact was what I would call a 'key' 1-day downside reversal; i.e., a move to new high, followed by a Close that was under the prior day's LOW.

The fact that the high point of the recent rebound also carried back up to my upper moving average resistance 'envelope' tended to support the idea that these recent highs ware going to be a place to exit calls and make a bearish play if you were going to play it all. The 'trading' envelopes for the indexes involve percentages also, presenting a level that is X percent above or below a centered moving average; in this case, the 21-day average. OEX near support looks like 582-580. Key resistance is at 590; a close over 590 is needed to suggest a possible move back up to the re-test the prior 604 high.

As far as the RSI, which I will expound on some more shortly, I most often use a 'length' setting on my DAILY chart of 13. In the RSI portion of the above chart, the recent high did not get to what would represent a common 'overbought' extreme, but does tell you that the Index was getting up close to an overbought situation. You have to look at such things in context.

How high did the Relative Strength Index get the last time that the market made an interim or tradable top? You can see that above and the levels were similar. The other thing that I will look at is the same indicator only applied to the longer-term weekly chart, where I use either an 8 or 13-week ('length') setting, sometimes both.


I like trading the Dow Index (DJX) options, as the Dow Industrials (INDU) often trades very 'technically'; that is, it tends to do things like stop and reverse at key trendlines, stop and reverse at key percentage retracements, stop and reverse sometimes at key moving averages like the 200-day average, etc.

INDU, as seen in its daily chart below, reversed to date after completing almost an exact 66% retracement. The retracements I look typically are 38, 50 and a zone between the 'fibonacci' 62% retracement level AND the equally important 2/3rds or 66% retracement level. You'll notice on my next chart that I have the 62 AND 66% levels marked; and of course they are quite close to each other.

Today's price action was bearish in the Dow, but was not quite the 'key' reversal that was seen in the OEX as INDU did not also go to a NEW high and then fall after that. But, it did decline to a new 12-day low Close. Key support is in the 11,000 area. Key resistance, especially on a Closing basis, is 11,300.

By force of habit and experience, I tend to use the 21-day Stochastic indicator most often in the Dow 30 (INDU) to provide an indication of when INDU is getting overbought or oversold. You can see how well this works on the chart above. I caution about using this indicator 'mechanically' so to speak; e.g., by buying calls when this indicator is reading around 20, buying puts when its up into the 80-90 area. There are times when the market of course gets 'oversold' and STAYS there and vice versa when the index 'hangs' up in the common overbought zone for a long period.

Again, I try to look at these indicators in CONTEXT; for example the Stochastic was both in what is often its overbought/reversal area and VULNERABLE (this is a potential only) to a pullback AND there was a completion of the aforementioned 66% retracement, which is can be a stubborn resistance.

Since I made a point of the 'common' use of 38, 50 and 62-66% retracements as areas to watch for possible support (downside retracements) or possible resistance (upside retracements of a prior decline), I now introduce one other 'wrinkle' to this subject of retracements. In very weak market, sometimes there is not more than a retracement of a quarter (25%) to a third (33%) of a prior move, before the prior trend resumes. This appears to be the case with the Nasdaq 100 Index (NDX) as seen in the chart below.

The retracement aspect ALSO needs to be seen in CONTEXT. The context here being that this market continues to be quite oversold and while there is an attempt to rally, the underlying conditions of weakness appear quite pervasive; individual and 'bellwether' NDX stocks notwithstanding, such as occurred with the strong earning-related rebound in Cisco Systems (CSCO). By the way, a rule of thumb is that when a stock (e.g., CSCO) is very oversold, bullish news will lift it farther and faster than will otherwise be the case.

This last NDX rally could not even get beyond a 'neutral' 50 reading in the 13-day RSI before price weakness started bringing the RSI back down again. To really see how oversold or overbought a market or a stock is, it's important to check out the weekly oscillators. That is to 'apply' them to the weekly chart. I tend to use the RSI for this almost exclusively, but some traders will more often use the MACD, which is fact was designed with weekly chart use in mind.

With the RSI on weekly charts, I tend to use either 8 or 13 as the 'length' setting. Normally, I use 8. If an index or stock is really languishing around a possible top or bottom, I will look at the 13-week RSI to better find the longer range extremes. You may notice that ALL the length settings I use are (the lower) 'fibonacci' numbers in the fibonacci number series; e.g., (5), 8, 13, or 21. Each number is the sum of the two numbers preceding it.

Firstly, the Weekly chart pattern is still bearish, so this is one context that the oversold extreme has to been seen within. The break in the Nasdaq 100 (NDX) Index of its long-standing up trendline led to steep further drop from May on. The pattern traced in the multiyear advance from 2003 was a bearish rising wedge. A double top then formed.

Recent rallies have formed bearish 'flag' patterns which are outlined in the rising light blue parallel lines in the NDX weekly chart below. Formation of such bear flag patterns tend to suggest more downside ahead. Significant technical support doesn't look like it comes in before NDX reaches the 1400 area.

The question would be how should we see the oversold extreme suggested by the 13-week RSI or what context? The last time that the RSI reached such a low RSI reading on the indicator above, it was not the first low RSI reading (at the mid-2002 bottom) that was associated finally with a sustained upside reversal; it was the second decline to a low point.

This pattern would repeat if NDX falls to the 1400 area and a potential double bottom and then starts to rebound after that. This would probably be a low risk call buy point, perhaps also for a longer-term buy and hold; the Nas 100 tracking stock (QQQQ) would be a possible vehicle for this strategy.

The S&P 100 (OEX) weekly chart is my last chart. Price action has tended to be back and forth within what is still looks to be long-term uptrend. The 8-week RSI is my choice to monitor any overbought/oversold extremes here. What is this indicator telling us? NOT MUCH!

The RSI is in mid-range or in a more or less 'neutral' reading. Since the long-term up trendline has not been pierced, I tend to want to buy calls more heavily at low RSI readings (especially at support implied by the up trendline) then I do puts at overbought extremes; although that last RSI reading above 70 when OEX couldn't gain traction above 600, highlighted decent potential in puts.

On the downside, if OEX starts to accelerate lower, the RSI will again be a useful backdrop indicator if and when it fell to around 30, especially if this occurs in conjunction when OEX again were to find support and solid buying interest in the 560-565 area.

That as they say, all he wrote. I was going to go into how the RSI and Stochastics are calculated, but have reached my deadline for sending in for your perusal dear readers. Besides, it's time to go surfing here on the Pacific I wish!

Please send any technical and Index-related questions for answer in Trader's Corner articles to support@optioninvestor.com with 'Leigh Stevens' in the Subject line.

** Good Trading Success! **

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