An OIN Subscriber asked me to explain how technical indicators that show an 'overbought' extreme week after week are all that useful. My answer is these type indicators are just a footnote when the market is in an especially strong trend, but other times are different.

In periods such as from late-September to now, a relatively short-term correction (16-17 trading days) was signaled by the most extreme Relative Strength Index (RSI) seen in many months. This when the 13-day RSI got up to 80; thereafter the S&P 500 (SPX) fell from 1227 down to an intraday low of 1173. That was the extent of the correction. Currently the same RSI model for SPX has gotten up to 77.4 as of today's close. In such a strong trend as this, the RSI is primarily going to show us one thing: the market is vulnerable to a correction. But the market can be vulnerable for an extended period of time and not much happen in terms of a pullback or trend reversal.

Regardless of immediate relevance, I continue to show RSI type indicators when I produce charts for my weekly Index Wrap. Why? Mostly because it's a reminder of a very strong trend and something of a 'constant' in terms of a condition ('overbought') I don't want to forget.

In terms of such overbought extremes being precise or effective as a market 'timing' indicator in a power move like we're in, it's not. Will another RSI reading of 80 mean a top like last time? Or will it be 82 next time, or 85. What I rely on mostly to 'signal' a correction in the strongest uptrends are reversal type chart patterns; e.g., piercing of a key trendline, a double top, a key downside reversal (subject of a future article), etc.

In terms of traditional overbought/oversold indicators, besides RSI there are the Stochastics and MACD indicators. I also consider my Trader 'sentiment' model seen above, to be another type of 'overbought/oversold' indicator. But such models relying on daily equities call to put volume figures are not usually lumped in with RSI, Stochastics and MACD. A prior Trader's Corner article. covered my market sentiment indicator and I won't go into this topic here.

Well, except to say, that some 'smoothing' in my daily sentiment number is needed and I rely on a simple 5-day moving average to highlight extremes. CBOE equities call volume on the last trading day of this past week (1/14/11) ran 2.7 times that of total daily equities put volume, which is very high. However, the 5-day moving average hasn't yet hit prior extremes. And, as with the RSI, we can't use such extremes as a 'timing' indicator in a runaway bull trend like we're in because we don't know WHAT extreme will coincide with a short or intermediate term reversal.

USEFULNESS OF HOURLY CHART EXTREMES IN THE 21-DAY RSI

In a very strong trend, up or down, there is some usefulness for short-term traders in following hourly stock index charts and noting where there are extreme readings on a 21-hour basis; i.e., using a 'length' setting of 21 on 60-minute charts. There tend to at least be minor pullbacks when, for example, hourly RSI Index extremes rise to and above 70 as seen above. Waiting for pullbacks after such readings is beneficial. Often, the most we can expect in such a strong bull trend is a sideways move OR pullback that brings the 21-hour RSI back down to at or near a 'neutral' 50 (RSI) reading before prices rebound again. The same is true when the market's weak: when the hourly RSI rebounds to or a bit above 50, prices may about to be headed sideways to lower again.

I started with some current specifics about how RSI extremes are of limited use in a very strong trend in terms of identifying entry/exit points. I'll next go to a more general discussion of overbought/oversold indicator concepts.

'OVERBOUGHT' AND 'OVERSOLD'

A first thing to point out with the concepts of overbought and oversold is that is that both terms are ALWAYS RELATIVE and 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' I mean whether a trader or investor is talking about intraday, a 2-3 day, 2-3 week or 2-3 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 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.

My first chart was suggesting how overbought SPX is as measured by a 13-day RSI. Here's a monthly SPX chart, using the same length setting of 13:

You can see on the above chart that the first RSI 'overbought' extreme that occurred over March-September 2000 was WAY early in terms of identifying a major top and the second RSI overbought extreme was close to corresponding to the price peak (in July-October 2007). And our current situation? SPX isn't close to being overbought on a very long-term chart basis. When you hear someone say the market is overbought or oversold, you have to think about what time frame they are 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., in the last 5 years, stock XYZ has traded between 50 and 75 a few times. After the first instance of this trading range, subsequent instances of trading at the low end of this range will result in an oversold extreme in the RSI. When the stock gets back up to 75, the stock will hit an 'overbought' extreme relative to this trading range.

In a strong bull or bear market on the other hand, as discussed already, the overbought/oversold concepts are less meaningful. A stock or index in a strong bull market will tend to go up and keep going up and stay quite overbought according to the conventional technical indicators for these things (e.g., MACD, Stochastics or RSI), for lengthily periods of time. The same is true in a bear market in terms of downside extremes. 'Conventional' technical indicators in a bear market that attempt to define overbought and oversold conditions are going to say that the market is oversold, and oversold and again, oversold!

BASICS OF THE OVERBOUGHT, OVERSOLD CONCEPT

A stock, stock index, commodity, etc. 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 years 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% 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 or index will correct.

Another example of an overbought condition might make an assumption about a stock that has closed higher for 10 days straight. If this price behavior is 'over' or beyond what is usual for this item, the assumption is that prices are vulnerable to snapping back and a rubber band analogy is a good one. Market valuations get stretched, so to speak, but then tend to also come back to a mean or an average. There is not always a precise, objective or agreed upon measurement of these concepts.

A central important aspect of overbought or oversold is that the concepts relate to a situation where there is a preponderance of hours, days or weeks (some specified period of time) where prices are moving strongly up or down. The concept of a specific price area that represents a level that is overbought or oversold does not normally come into play; only that price momentum or the rate (speed) at which prices change, is stronger than usual and predominately in one direction. Experience then suggests that at some point, after a market gets into the common overbought or oversold ranges of 70 to 30 respectively, there is an increased likelihood that there will be a counter-trend move.

There are two important things that an overbought or oversold extreme can highlight:

1.) A potential for a sharp countertrend move AND

2.) Where there is a price/RSI bullish or bearish DIVERGENCE such as seen below from my historical chart file.

After the bullish price/RSI divergence seen in my next chart, OEX went initially to 487, pulled back to the 400 area again and then started a multi-month bull market that took the index to 573. In terms of the 2003-2007 bull market, OEX got to 727.

The two settings for the indicators above RELATIVE to how we will define overbought or oversold have to do with LENGTH and numerical LEVEL of the indicator; i.e., what number of hours, days, weeks or months we want the indicator formula to use (length) and what high/low settings we use to 'define' what is an overbought or oversold area or level.

In the OEX chart above, I am using a length setting of 14 for both RSI and Stochastics; i.e., the formula measures the most recent close relative to the highest high and lowest low for the past 14-days. If this was an hourly chart, it would measure 14 hours, etc.

I define oversold/overbought levels as 30 and 70 for the RSI above, which is a typical 'default' or common setting or definition for the start of those extremes. I use 20 and 80 for the 14-day stochastic, also a common default setting.

We see two things in the chart above: the most recent low was oversold according to the stochastic model and nearly so according to RSI, however not as oversold as at the prior low. Leaving aside the related and obvious potential for a technical double bottom in the OEX, there is another bullish technical factor shown above (and in the weekly NDX chart below), that of a bullish PRICE/RSI-STOCHASTICS DIVERGENCE.

In a bearish divergence, prices make higher highs, but the RSI or other such indicator does not ALSO make a higher high along with prices. I tend to use to the RSI most in spotting potential divergences as it tends to highlight them most often. This has to do with it being a ratio of down closes to up closes and to being a single reading and single point or plot. However, you see from the example chart above that Stochastics highlighted this bullish divergence quite well also.

For the weekly chart below of the Nasdaq 100 (NDX), not only does the RSI tell us (on a 13-week, 1/4 of a year basis) that the index was registering an oversold extreme common in a bear market, but that the last low on the chart was not 'confirmed' by a similar lower low in the RSI.

With such a bullish divergence, actual proof of the technical pudding so to speak is a breakout above its down trendline and a move above a prior swing high. This of course happened after the end point showing on this chart as NDX went to 1500 and above.

A bullish divergence is seen not only when prices go to a new low unaccompanied by a lower low in the RSI, but is also seen in a situation as seen below where prices trend sideways representing a possible bottom, which was also 'confirmed' by an UPtrending RSI. The addition of my highlighting a bullish price/RSI divergence is here added to an hourly chart first seen above.

Both bullish AND bearish price/RSI divergences are seen in my last chart, taken from my (Essential Technical Analysis) book.


GOOD TRADING SUCCESS!