Option Investor
Trader's Corner

Indicators Useful in One Timeframe, Not Another

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I sometimes wonder, especially when I see all the complex chart and indicator analysis that can get thrown at you in these daily e-mails, if I am not too simplistic in my KISSES; as in "Keeping It Simple Stupid". The stupid would be me if the best market analysis is the MOST complex, which is a dialectical principle well known in the old Soviet empire; that is, quantity becomes quality. The more stuff pumped out, the more desirable, valuable, etc. that it (the analysis in this case) is.

In my years in Wall Street, or as I like to think of it fondly at the Street of Dreams, a good number of the most successful individual traders I knew or knew of from close associates, operating on guts, experience, instinct, some technical principles, charts, etc. had fairly simple rules in predicting market trends from hour to hour, day to day, and week to week. Here I am not talking about the 'quants' or bright computer geeks such as those using very sophisticated arbitrage models and the like to make a lot of net (often small) profitable trades.

I am talking about the likes of Paul Tudor Jones, my old mentor Mark Weinstein (not the market analyst), who you've never heard of and never will, S&P Index Trader Marty Swartz, currency trader Ed Seykota; well, Ed always pretty much used computer models, but his psychological insights as to who wins in trading was/is very straightforward and masterful.

Anyhow, I was thinking about the fact that I like to use the concepts of 'overbought' and 'oversold' in trading, but how to employ such a tool as the Relative Strength Index (RSI) in a strongly TRENDING market requires not giving up this analysis tool or indicator entirely, but also knowing under what conditions, mostly in what chart TIME FRAME, the indicator would be useful as a timing tool.

This market has had a number of price swings in BOTH directions in the Indexes, with knowing where pullbacks might develop sometimes just useful as to when to take profits on calls and then judging when to get back in (to calls). Of course many stocks have been going up, but others have had sizable declines along the way or have traded in a broad range. It is perceived of course that individual stocks, especially the high-beta ones with sizable trading swings, are where you could and maybe should trade in and out more.

Trading in and out is more difficult in the stock indices with a dominant strong trend, but it can also be difficult to just buy and hold like a stock. We got TIME PREMIUMS to worry about, which is a big concern when the trend goes sideways for some days and weeks.

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OVERBOUGHT/OVERSOLD CONCEPTS:
A stock 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 is a relative term and implies a trading judgment that that major surges in buying (or selling) well in excess of what is usual on an historical basis, also creates an increasing 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 day or 2-3 week trading horizons.

The classic technical indicators that you can 'apply' to a chart with most trading software on charting (web) sites, are the Relative Strength Index or RSI, the (slow) Stochastic model and the MACD (Moving Average Convergence Divergence). These indicators tend to be used with the same basic formulas, and what VARIES is the 'length' setting; that is, how many bars the indicator references. Use of the term 'bars' means that for any time frame being charted, such as 15, 30, 60 minutes, a day, a week or month, the indicator will take X number of bars and calculate based on the CLOSING price for 5, 10, 14, 21, etc. hourly, daily or weekly bars or trading periods.

I like the RSI for its precision and it is basically a ratio of an average of UP closes, relative to an average of DOWN closes for the period specified as 'length'. If a stock or an index goes pretty much straight up or straight down for 13 (trading) days, in the case of a 13-period RSI used on a daily chart, the RSI is going to shoot up to the upper end of its SCALE. The scale in a so-called 'normalized' overbought/oversold indicator oscillates between zero and 100 and the formula for these so-called 'oscillators' is designed that way; unlike the MACD, a similar type indicator, but one that requires comparing current levels to past periods, not a high number near 100 or a low number near zero.

The historical RSI level considered 'overbought' is 70 and above; for 'oversold', it is at or under 30. I tend to find that a ZONE between 65 and 70, and above, is the area to look at on the upside; on the downside, focus on the 35-30 zone and under, as defining an index or stock that is getting 'oversold' potentially.

NOT WORTH A PILE OF MANURE

In a strongly trending market, such as in the rising/bull market we've been in, concepts of overbought and oversold mean about as much as the foregoing title line. Indexes or stocks soar up to the upper end of the RSI scale and tend not to come back down on a DAILY or WEEKLY chart basis, as there may not be (for a long time) any period when a counter-trend move puts the indicator back down even close to an 'oversold' reading. Such is the nature of bull markets; or, of the reverse situation in a bear trend where the indicator drops to the lower end of the scale and then never really rises enough to suggest an 'overbought' situation.

My first chart, that of the daily S&P 500 (SPX) Index demonstrates all the foregoing well as to a market that gets 'overbought' supposedly but not 'oversold'. In the SPX chart 13-day RSI, of what trading use is an indicator like this registering just an upper overbought area? Zero!

The RSI shown above, as reflecting price action, doesn't fall back to an 'oversold' reading and suggest perhaps another buying opportunity.

We're told that the RSI and other oscillator type indicators are useful mostly or only in a TRADING RANGE market. It's hard to find examples of stocks that are in a defined 'trading range', but there are some having back and forth price swings within this strong bull market trend we're in. I probably could have found other examples using other Dow stocks, but the Intel daily chart below, also employing a 13-day RSI indicator below the price graph, does show some up (overbought) AND down (oversold) extremes:


HOLD THE PHONE, STOP THE PRESSES...

There HAS been a useful length and chart setting suggesting the points where an overbought and oversold condition sets up on a 21-hour basis. (21, along with 13, being a Fibonacci number.) I note in the S&P 100 (OEX) hourly line (close-only) chart below the approximate point value of price swings that occurred from 21-hour RSI readings in the overbought zone, followed by hourly RSI readings in the oversold zone and vice-versa.

I use a zone between 65 and 70 (and above) to 'define' an overbought condition and a zone between 35 and 30 (and below) to define an oversold reading. I picked an index has an active option trade but hasn't exactly been where the 'action' is; nevertheless that have been some good trading swings.

Not all oversold readings shown above were followed by a peak reading in the overbought zone; not all overbought readings were followed by a move that results in an RSI reading in or below the oversold zone. We can't just rely on just this indicator to trade by, but its been VERY useful to suggest areas to buy, areas to sell, assuming you are looking to trade some of the 2-3 day, 2-3 week price swings that developed in past weeks.

My next and last chart is looking at the same hourly chart and RSI setting, only for the Nasdaq 100 (NDX). Enough said, a 'picture' here should we worth more words on this subject; and give you some ideas of a very useful way to use an indicator that hasn't been of much practical use on daily or weekly charts and you may have discarded so to speak.

Hopefully, your charting application will allow you to look at a longer period than say 10 days of hourly data. The more the better! My hourly data, stored 'locally' on my PC, goes back for many months.

GOOD TRADING SUCCESS!

** E-MAIL QUESTIONS/COMMENTS **
Please send any technical and Index-related questions for answer in Trader's Corner articles to Click here to email Leigh Stevens with 'Leigh Stevens' in the Subject line.
 

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