Why You Should Beware Of This Type Of Indicator…

Investors use technical indicators often. The goal: find a trading edge, whether that comes in the form of identifying more winning trades than losing trades; or timing entries into trades to catch bigger winners and smaller losers. Many people claim that they can gain an edge by using indicators, but experience shows most fail to work as advertised.

Among the worst-performing indicators are some of the most popular used to describe markets with simple terms like “oversold” or “overbought.”

An “oversold” market is one where prices move to the downside too quickly and traders expect a quick reversal to the upside. “Overbought” markets are seen when prices rise too fast and traders expect a reversal to the downside.

How Traders Find “Overbought” And “Oversold” Extremes

There are a number of indicators developed to identify market extremes. (The Relative Strength Index (RSI) and stochastics are two examples.) The theory behind these indicators is relatively simple. It’s based on the belief that price action behaves like a rubber band. When a rubber band is stretched too far, it will snap back. So when prices are stretched too far in one direction they should snap back in the opposite direction.

There are a number of ways to define when a market is overbought or oversold. One of the simplest is to compare the price to its moving average. If the price is more than 10% above the moving average, the market can be considered overbought. An oversold market can be defined as one where the price is more than 10% below its moving average. This concept works with any moving average and with any time frame.

One reason this indicator is widely used is because it’s easy to find overbought and oversold extremes visually. RSI or stochastics require spotting those times when the indicator moves through a key level (70 and 30 for RSI or 20 and 80 for stochastics), and those patterns are often difficult to spot on charts.

Stocks Can Stay “Overbought” Or “Oversold” For A Long Time

Consider the example below for Visa (NYSE: V). In this chart, a 10% band has been applied to a 10-month moving average. According to this indicator, V was “overbought” for years. Traders expecting a decline were disappointed.

In fact, if you do a long-term study of V’s price chart, you’ll find that it has been overbought for most of its trading history by this measure. Yet it has suffered few setbacks in its trading history.

The same pattern can be seen on the downside. Consider the PowerShares QQQ Trust (NASDAQ: QQQ), which tracks the Nasdaq. Again, a 10% band and a 10-month moving average are used in the chart. In the aftermath of the dotcom crash, the ETF was “oversold” throughout the bear market. Yet this never led to a rally — and it would take nearly 10 years for the index to regain its former highs.

The bear market in 2008 also remained oversold for an extended period of time.

Other overbought and oversold indicators yield similar results. Testing shows that traders will not usually be profitable using indicators like RSI or stochastics with the standard settings to buy and sell.

The reason these indicators rarely work well is because in the long run, markets follow trends rather than behaving like a rubber band. When they are trending, the size of the price moves tend to be large. During these trends, prices will remain overbought or oversold for extended periods of time.

There are times when overbought/oversold indicators will work. This will happen when prices are not trending. The price moves at these times will be rather small when compared to the changes seen during trends.

The Takeaway

Overbought and oversold indicators should never be applied to market analysis. They are best used to identify short-term trading opportunities in a group of individual stocks. When using these indicators, experiment with different values such as a 2-day RSI or buying when the stochastics indicator falls below 5. If a large number of stocks are scanned for opportunities each day, there should be a number of trading candidates with this approach.

The point is, you should only use indicators for their intended purposes. Overbought/oversold indicators are designed to spot short-term reversals and should only be used as short-term strategies. Because these indicators are for trading rather than analysis, use a well-defined exit strategy, like selling five days after buying.

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