How to Tell if an ETF Is Overbought or Oversold

01/29/2010 12:01 am EST

Focus: ETFS

David Penn

Editor-in-Chief, TradingMarkets

ETFs are an exciting market for traders. ETFs allow traders to trade whole markets or financial sectors. ETFs also make it possible for traders to avoid single stock risk and to hedge investments in other instruments, from stocks to bonds to commodities.

But what opportunities do exchange traded funds (ETFs) offer traders, especially short-term traders?

We have done extensive research into exchange traded funds, in some instances backtesting ETF trading strategies all the way back to the mid-1990s. And what our research has uncovered with regard to exchange traded funds (ETFs) parallels what we have discovered when it comes to stock price movement in the short term: There is a short-term edge in buying oversold ETFs above the 200-day moving average, and in selling short overbought ETFs trading below the 200-day moving average.

Overbought to Sell off: Short-Term Highs Below 200-Day MA Lead to Downside Opportunities

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Let's say that again because it is the crucial aspect of our high-probability approach to trading exchange traded funds in the short term. When ETFs are trading above their 200-day moving averages, we look to buy them on pullbacks after they have become oversold. When ETFs are trading below their 200-day moving averages, our strategy is to sell them short on bounces after they have become overbought.

If that sounds simple, then you're right, it is simple. But that's the way we like our short-term trading

strategies.

Our approach to short term trading—in ETFs as in stocks—is simply to uncover an edge, a natural tendency in the markets, and then to look for ways to take advantage of that edge through timely trades. It is a natural tendency of markets to move from overbought conditions to oversold conditions and back again. This happens during market rallies, market declines, and even when markets are moving sideways.

Oversold to Rally: Two-Period RSI Is Excellent Tool for Short-Term Traders Looking to Identify Overbought and Oversold Markets

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What our research has revealed is that traders can take advantage of this natural tendency by trading these markets in the short term—buying markets after they have become oversold, but before they resume their advances back toward overbought conditions. On the short side, we found that it was possible to make high-probability, high-win-rate trades by selling short markets after they have become overbought, but before they begin their inevitable short-term selloff.

All that is required to do this are two things: The 200-day moving average (we never buy ETFs below it and never sell short ETFs trading above it) and a way to determine when an ETF has become overbought or oversold.

Whether markets are trending upwards, downwards, or oscillating in a sideways fashion, markets have a tendency to move back and forth from overbought to oversold conditions. This movement is not mysterious; it is simply the product of the buying and selling of millions of traders and investors.

Short-term traders can take advantage of this natural market movement by waiting for markets to reach extreme levels of overbought and oversold. This strategy of selling overbought markets (that are below their 200-day moving averages) and buying oversold markets (that are above their 200-day moving averages) is the cornerstone of our high-probability approach to short-term trading.

The big question is how do you know when an ETF is overbought or oversold?

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Short-Term Closing Low in DXD Above 200-Day MA Appears Just Before Major Advance

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Today, I will present one method that any ETF trader can use immediately to know which ETFs are overbought from a trading perspective and which are oversold.

Another key insight from the research of Connors and Alvarez is that markets tend to perform better in the wake of short-term lows rather than short-term highs-especially on a closing basis. This has been a consistent finding in the research whether the subject was the market as a whole, individual stocks, or individual ETFs.

These findings, I should point out, are robust, meaning that the actual length of the short-term low can vary without undermining the results. We have tested a variety of short-term lows-especially closing lows-and found those around seven days to be especially helpful in identifying potentially oversold markets.

Similarly, markets making short-term highs, which have tested to produce underperformance in the short-term relative to markets making short term lows, may be considered overbought markets from a high-probability trading perspective.

Short-Term Closing Low in DXD Above 200-Day MA Appears Just Before Major Advance

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The research on these short-term highs and lows (again, especially on a closing basis) was impressive enough that we built an entire ETF trading strategy around it. That strategy is called “Double 7’s.”

So if you are looking to buy oversold ETFs on a pullback, look to see how close they are to their short-term closing lows. If those ETFs making short-term closing lows are also trading above their 200-day moving averages, then you just might have a trading opportunity to the upside on your hands.

Our research going back to the mid-1990s in the SPY, and since inception for most other widely traded ETFs, tells us that there is a short-term edge in buying ETFs that are exceptionally oversold and in selling short ETFs that are exceptionally overbought. This approach to trading is explained and discussed in great detail in Larry Connors' new book, High-Probability ETF Trading.

In the second part of our series, I revealed one basic strategy that ETF traders can use to determine when an ETF is overbought or oversold. This strategy of looking to potentially buy ETFs making short-term closing lows (short term meaning five to nine days) and potentially selling short ETFs making short-term closing highs is one that any ETF trader can include in his or her short-term trading of ETFs. In fact, the “Double 7’s” strategy is specifically designed to take advantage of this edge.

NEXT: The Most Valuable Tool for Finding Overbought/Oversold ETFs

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Here in the final part of our series on finding and trading overbought and oversold ETFs, I want to introduce what is probably our most valuable tool in determining whether or not an ETF is overbought or oversold: The two-period RSI.

High Two-Period RSI in IWM in Early January Helped Signal Short-Term Reversal to Down Side

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Anyone who has followed the research of Larry Connors and Cesar Alvarez knows how much we appreciate and rely on the two-period RSI. We have gone so far as to suggest that it might be the best short-term indicator available for traders, especially high-probability mean reversion traders.

How do we use the two-period RSI to spot overbought and oversold conditions? When it comes to ETFs as opposed to stocks, we use levels very close to the standard overbought and oversold levels used by most technical analysts. Over 70 signifies overbought conditions, and under 30 signifies oversold conditions. The key difference is in the shortness of the tracking period, two trading days instead of the default, 14 days. Our testing has found that the shorter duration RSI does a much better job at helping detect potential short-term turning points as compared to the 14-day version.

Pullback Toward 200-Day MA and Plunging Two-Period RSI Alerts About Short-Term Upside Opportunity in QID

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Combined with the filter of the 200-day moving average (never buy below it, never sell short above it), the two-period RSI is an invaluable tool for traders trying to spot those ETFs that have been sold too aggressively, as well as those ETFs that have become overvalued and bid too high. The next time you are thinking about buying an ETF for a short-term trade, take a look at its two-period RSI and see if you are buying an ETF that is overpriced and already in high demand, or an undervalued ETF that a desperate owner has (fortunately for you) put on sale.

By David Penn of TradingMarkets.com

David Penn is editor in chief at TradingMarkets.com. With Larry Connors’ High Probability ETF Trading Software, short-term traders have access to the same kind of "Buy the selling, sell the buying" trading strategies that professional traders have used successfully for decades.

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