OIN SUBSCRIBER QUESTION:

"I've heard comments that the market is overbought but is keeps going up regardless. You've said the same but have stayed generally bullish I believe. How important is the concept of being overbought or oversold anyway?

RESPONSE:

Well I talk about it when the Relative Strength Index or RSI is showing an extreme, as these periods tend to be when corrections happen but we can't know how stretched out this will be. Moreover, in a strong bull market, corrections are less likely to be deep and prolonged.

Conversely, in a powerful bear market, rallies are less likely to retrace a lot of the prior decline before there's another fall.

With technical analysis, with its two inputs of price and volume, which is all technicians work with, price patterns are foremost. All indicators are derivatives of price and/or volume. That's all there is. A 3rd consideration, not formally part of technical analysis, involves indicators derived from attempts to measure the mood, attitudes or psychology of traders or how bullish or bearish they are; i.e., types of 'sentiment' studies.

So, 'overbought/oversold' models are indicators that derive from closing prices usually, on intraday, daily, weekly or even monthly charts. Indicators are SECONDARY considerations in the study of the current market trend, including the prospect for a correction or trend reversal.

I'll go into some general basics and then look at some current charts, ranging from hourly, to daily to weekly charts as it relates to trend and 'overbought' concepts. Obviously in a strong bull market like this one, we're seeing multiple and reoccurring instances of what traders and analysts call an 'overbought' situation. I will use the RSI indicator as my model for this, as opposed to Stochastics or the MACD studies.

'OVERBOUGHT' AND 'OVERSOLD'

The first thing to point out with the concepts of overbought and oversold is that both terms are always RELATIVE. Overbought or oversold means that a stock or index is thought to be at an extreme (on the downside or upside). But a stock or an index is only 'over'-bought or 'over'-sold in terms of both TIME and CONDITION.

TIME

By time is meant, are we talking about on an intraday basis (e.g., on an hourly basis, on a 2 to 3 day, 2 to 3 week, or 2 to 3 month time frame? A stock or index is thought to be at an extreme only relative to, or in terms of, a certain period of time. For example, the S&P 100 (OEX) might be thought to be quite oversold because it went down sharply down for 5 straight days. However, this might be in the context that the index went up strongly for 5 straight weeks or, 5 consecutive months.

In this OEX example, on a longer-term basis the index is not oversold at all and may in fact be considered to be still 'overextended' or overbought on the upside after 5 down days. When you hear someone say the market is overbought or oversold, you have to think about what time frame are they talking about.

CONDITION

By 'condition' I mean that the relative terms overbought and oversold mean different things in different market conditions or different types of markets. Overbought and oversold are BEST defined in a market that is in a fairly defined trading range; e.g., for the last two years, stock XYZ has traded between 50 and 100 several times. When the stock is at 50 it is oversold and when it's at 100 it’s overbought RELATIVE to this trading range.

In a strong bull or bear market on the other hand, the overbought/oversold concepts are less meaningful as a stock stocks (an index) will tend to go up and keep going up and stay overbought, according to the conventional technical indicators for these things (e.g., MACD, Stochastics or RSI), for lengthy periods of time. The conventional indicators that attempt to define the relative concepts overbought and oversold in a strong trend are going to say that the market is overbought, and overbought and again, overbought!

However, this doesn't mean that the overbought concept is meaningless. As can be seen in my first chart, overall market corrections tend to occur when the major stock market indexes are in, near or above the 'typical' overbought zone; e.g., using the 13-period or 13-day RSI on a daily chart.

INDICATOR SETTINGS:

There are only two changes or inputs that the average trader will make for any of the overbought/oversold indicators. The two settings for the indicators above relative to how we will define overbought or oversold and have to do with period LENGTH and overbought or oversold LEVELS. As to the 'length' setting this refers to the number of hours, days, weeks or months we want the indicator formula to use. The overbought/oversold 'levels' are the level lines that we will use to 'define' what is the line demarking an overbought or oversold level.

The common default level you'll see for overbought is 70 and for oversold 30. I define usually a zone for overbought and oversold that is based on the general RSI area where upside or downside trend reversals have occurred in the last 6 to 12 to 18 months; e.g., between 65 and 70 for the upper 'overbought' zone. These zones change depending on whether we're in a strong bull trend, a bearish down trend or a broad trading range.

You'll often see a default setting for length in the RSI of 14. I use 13, mostly because of my penchant for the use of fibonacci numbers. Use of either 13 or 14 on daily charts will make for relatively minor differences in RSI readings.

As to the overbought/oversold group of indicators, I use the Relative Strength Index or RSI rather than the Stochastic model or the Moving Average Convergence Divergence (MACD) study; I can cover these indicators in a different article. I use different RSI length settings depending on whether I'm studying an hourly, daily or weekly chart. 5, 9, and 14 are common 'default' settings for the RSI that you'll see.

Since I want to look at a bigger picture I use 13 for a daily chart rather than the something as short as a 9-day RSI. I'm sold on use of the 21-period RSI for HOURLY charts and either 8 or 13 length settings for weekly charts. These numbers are part of the 3, 5, 8, 13, 21, etc. fibonacci number progression; i.e., each number is the sum of the 2 prior numbers.

Starting with the smaller scale hourly chart of the Nasdaq 100 index, the current rally had initial price patterns that were bullish and NDX has been in a strong rally phase since. In terms of the 21-period RSI, the uptrend slowed over Thursday and Friday after the RSI got to the highlighted overbought zone seen below. This is a fairly CONSISTENT pattern in terms of price action relative to the RSI indicator.

In terms of PRICE considerations alone, the current powerful uptrend remains intact on the basis of the daily and weekly charts. Judging the situation by NDX's hourly up trendline this leader of the indexes is losing its prior rate of (upside) momentum, was hitting similar hourly highs and by Friday was under its hourly up trendline. This could suggest a pullback or retracement of a portion of the last advance. Price action may then 'confirm', the 'overextended' or overbought condition suggested by the RSI. Time will tell on whether this is the start of a minor, or more significant, correction.

The most useful chart for trading the bigger price swings is the daily chart and while you see many instances of overbought readings on the 13-period RSI, there are patterns here as I've noted on the chart. Price wise, corrections in an uptrend often consist of a pullback, another rally, followed by a second pullback, followed in turn by another strong advance.

In a strong uptrend the corrections aren't deep but are significant to many if not most options traders. They tend to start from periods (as seen below with OEX) when the RSI is registered an overbought reading; i.e., there has been a steady advance for some period of time. Subsequent rallies don't typically start from what I would call a 'fully' oversold reading, but are more likely to begin from a mid-range 'neutral' RSI zone which is common in strong bullish trends; this rather than from a 'fully' oversold reading around 30.

On a weekly chart basis, I tend to use either an 8-period or 8-week length setting, sometimes a 13-week setting. I've noted the other very useful aspect to the RSI relative to price action, which is where the RSI doesn't follow prices to new relative highs and diverges in this sense. Conversely, prices make lower lows but aren’t matched by a similar new low in the RSI.

Successive new weekly highs in the S&P 500 (SPX) in 2007 were not matched by new relative highs in the 8-week RSI. This divergence developed over many weeks. This diverging pattern between indicator and price action wasn't immediately useful but it did suggest an eventual downside reversal and a massive one at that.

Last but not least is the weekly Nasdaq Composite (COMP) chart and here I've used a 13-period RSI. In terms of price action COMP is now well ABOVE it's major down trendline and has retraced more than 50% of its last major decline. This, versus SPX, which still has some distance to go to equal this much of a retracement (as seen above).

COMP is also registered an overbought extreme above 70 in the longer length (13) RSI. What does or will this mean? For sure we do know that some unexpected bearish event will hit harder in an overbought market than would be the case otherwise.

We also know that in a strong advance an overbought extreme can go on for some time. Prices might just level off some although COMP is in a recently accelerating surge higher.

We can't know just when there will be a next significant correction, but we can say that the odds for it have increased. Whether in 1, 3 or 6 weeks, a next sizable pullback shouldn't catch you completely napping!

THE RSI FORMULA:

The Relative Strength Index or RSI is an indicator in the class called oscillators that are constructed in a way that their numerical scales go from 0 to 100. The formula is said to be 'normalized'. This is not the case in the Moving Average Convergence Divergence or MACD ('mack-dee'), which can be a subject of another article on the overbought/oversold types of indicators.

The Relative Strength Index, usually referred to as the RSI, was developed by a trader and market analyst named Welles Wilder back in the 1970's. A simple way to understand the RSI is that it is a RATIO (one number divided by another) that compares an average of up closes to down closes. There is only ONE variable in the actual formula for RSI (versus the levels lines 'defining' overbought or oversold levels) which is the LENGTH or the number of periods (hours, days, weeks, etc.) that the RSI formula works with.

RSI is derived by calculating the average number of points gained on up days, during the period selected (e.g., 13), then dividing this result by the average point decline for the same number of bars, a ratio called 'RS'; i.e., 100–100/1+RS. RS in this example of a length setting of 13 will equal the average of 13-days' up closes divided by an average of 13-days' down closes. 9 or 21, or any other number, could be used instead of 13 in this example.

Every up close during this period is added and this sum is divided by the number of bars that had up closes to arrive at a simple average. Every down close during the period selected is added, then this sum is divided by the number of bars that had down closes. If 10 of 13 days had up closes, the result of this division is a ratio that rises rapidly. Subtraction from 100 of the result of the division is what makes for a 'normalized' scale of 1 to 100.

In a period of a rapid and steady advance the RSI will reach levels over 70 rather quickly and RSI can then remain above 70 for some period of time. A subsequent sideways or lower trend, even slightly lower, will cause the RSI to fall back under 70 rather quickly and to fall further to a more 'neutral' reading between 55 to 45.

The reverse is true in a rapid and steep decline, as readings under 30 will soon be seen. A subsequent sideways or higher trend, even slightly higher, will cause the RSI to rebound above 30 rather quickly and to rise further to a more 'neutral' reading between 45 to 55.

That's about it on the RSI formula.


GOOD TRADING SUCCESS!