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Trader's Corner

Overbought and Oversold Readings Are Often Overrated

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Your favorite indicator has just moved into overbought territory. It may be time to sell, you're thinking.

Maybe not.

Annotated Daily Chart of the TRAN:

For traders unfamiliar with overbought or oversold measurements on lower indicators, many charting programs have default settings at which these lines are drawn. For RSI, those default lines are often drawn at 70 on the topside and 30 on the bottom, although some traders prefer 80 and 20 settings instead. RSI can vacillate from 100 down to 0, but once it gets beyond those 70 or 80 settings on the top and 30 or 20 on the bottom, the move has become extreme. In a range-bound trading situation, that's often a signal that a reversal might soon be expected.

That's not the case in a trending market, however, as the TRAN's chart illustrated. As can be judged on that chart, in such cases, the so-called overbought rating was instead signaling that upside momentum was strong. Going long a call would have been a much better choice than buying a put.

What tools can a trader use to identify those times when overbought is not overbought so much as still-going-strong or when oversold is not oversold but getting-weaker-by-the-minute? Coupling a bottom indicator such as RSI with a top indicator such as a Keltner channel, Donchian channel or even Bollinger band might help.

The next chart employs my favorite channel system, Keltner channels, to illustrate the point.

Annotated Daily Chart of the TRAN:

The choice of Keltner channels to make this point was particularly appropriate, since Keltner channels were designed specifically to identify breakout plays. Breakouts indicate that momentum is strong in the direction of the break.

How does one use such observations? I use them to warn me when a trending situation might be setting up. I don't tend to trade breakout plays too often, but some do use such observations to trade breakout plays. Price Headley, a webinar presenter on www.cbot.com, is one of those.

He uses proprietary top and bottom indicators to determine such setups and offers some further guidelines for those who would trade breakouts. For example, he would not have considered that first RSI dip back below 70 in mid-November to be an automatic exit signal for a long breakout play. In fact, he argues that such minor dips often offer new bullish entries, as long as prices continue to close the day above the channel line that marked the breakout. In the case illustrated above, that would have been the black upper Keltner channel line.

That's not a tactic that I've backtested and can verify, but it certainly worked in this case. Headley additionally cautions that it's the close of the period being watched that's important, not intra-period moves. I certainly agree with that observation when using Keltner channels, which Headley wasn't using. Candles often pierce a Keltner channel during a period, but then close in such a way as to show that support or resistance held.

Headley cautions that, if at all possible, traders should wait until that close before making any decisions. Of course, if prices reverse strongly during a period, waiting might not be possible or might not even be a sound account-management tactic.

In my own case, I consider breakouts to be in force until prices begin closing consistently below the breakout channel. I don't tend to trade breakouts, as those kinds of trades don't fit my trading style or temperament, but I do use these observations to tell me when my assumptions about the strength of resistance or support might be wrong.

Some studies in the past tagged breakout plays as the most profitable in the long run but only for those traders who had the funds, patience and stamina to endure many whipsawed trades. I have the funds and the patience to endure the whipsawed trades, but not, conversely, to hold onto a winning play. I tend to want to close out and pocket my profits, protecting them. That doesn't work for someone trading breakouts because the profits must be allowed to run to make up for the many whipsawed trades. Having two out of the three necessary qualifications doesn't cut it when trading. I lack the stamina to hold onto the winning plays long enough to make up for those whipsawed ones.

Maybe you think you have all three qualifications and want to trade breakouts. If so, coupling an upper channel system breakout or breakdown with a lower indicator reading of overbought or oversold might help you identify potential breakout plays. I caution again that this isn't a methodology that I've tested for this use. Traders leaping on breakout or breakdown plays need to adhere to their hard stops, because reversals from overbought or oversold levels can be hard if the breakout fails.

For the rest of us, this method helps warn us that a directional move is strong and that we should perhaps not trust those overbought or oversold readings. They can be overrated as a useful sign of a reversal when markets trend.

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