|Analysts love to show off by proclaiming that the markets
have become overbought or oversold. Unfortunately, few of us
seem to understand what these terms really mean or what we
should do when these moments of truth arise.
||Should we run for the hills because a market is overbought, or
perhaps load up the boat because it's oversold? And how do we
know when one of our trades might fall prey to one of these
extreme conditions? The best way to understand overbought or
oversold markets is to study the nature of supply and
demand. At any given moment, a finite pool of buyers and
sellers is available to take action on a particular
activity of this crowd usually stays within fairly
But imbalances develop over time and force one side to pull the
trigger, sometimes prematurely. This "uses up" that side of the
market and awakens price mechanics that favor the other side.
Bollinger Bands offer an effective tool for measuring
overbought/oversold conditions. Notice how Nvidia (NVDA:Nasdaq -
news - commentary - research - analysis) triggers a short-term
reversal each time price bars thrust outside the extremes of the
20-day Bollinger Bands. These outer bands tell swing traders to
expect a reversal before real evidence appears on the price
chart. This allows them to take high-profit exits while the rest
of the crowd is caught in the moment.
It's important to note that overbought/oversold markets are
relative to a trader's time frame. In the NVDA chart, some
reversals were simple pullbacks in the underlying trend, while
others represented major market turns. It is vitally important
for traders to define their holding period before reacting to
short-term price swings. Major profits will be lost by planning
the trade in one time frame but executing it in another.
Stochastics represents the classic overbought/oversold
oscillator. Unfortunately, most traders don't understand how to
interpret the information it provides. The worst thing you can
do is jump ship just because stochastics hits a high or low
extreme. Most swing-trading profits are booked in the early
stages of overbought or oversold markets. Of course, that's
where most of the risk is as well.
Use simple double-top or double-bottom patterns to pinpoint
reversals driven by overbought or oversold conditions. The best
signals come when stochastics makes a lower high (or higher low)
and expands in the opposite direction. This type of pattern will
often complete ahead of price change, and should be acted upon
without waiting for further confirmation.
A single price bar can change everything. Stocks trade with
an average high-low range through most market conditions. When
this range expands sharply after an extended trend, it issues a
loud overbought-oversold signal.
What exactly does this mean? First off, when a price bar expands
in a new breakout, it's the beginning of something and not a
reversal signal. But when a stock ramps from one price level to
another, and then pops an expansion bar, get ready to close up
shop in a hurry.
Traders must deal with the relativity of overbought/oversold
markets. A longer-term Wilder's relative strength index (RSI)
really drives home this vital point. It captures broad cycles of
market movement, and it can stay at overbought or oversold
levels for extended time periods.
As with the stochastics indicator, hold your ground until RSI
shows definite signs of moving in the other direction. This
usually comes when it drops below (lifts above) the extension
line. Even then, compare RSI with the price pattern to determine
whether a major turn, or simple pullback, is under way.