A Different Look at Overbought and Oversold

01/17/2008 12:00 am EST

Focus: STRATEGIES

Thomas Aspray

, Professional Trader & Analyst

There are many methods that can be used to measure whether a market is overbought or oversold, several of which we have discussed in past articles. One of my favorites is the STARC bands; however, they do not provide a long-term historical view. One phenomenon that I have watched continually over the years is the gap between prices and a moving average, which I have found to be helpful in entering and exiting positions. While this is a relationship that I have often used on a subjective basis, I have never attempted to quantify it until recently.

One of the moving averages I use for longer-term analysis is a 34-period exponential moving average (EMA). This is the average I thought would best identify intermediate- to long-term extremes using weekly data.

Figure 1
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The chart above covers twenty years of trading in the S&P 500, and goes back to include the 1987 decline. On the bottom of the chart is plotted the difference between the weekly close and its 34-week EMA expressed as a percentage of the EMA. In 1987, the majority of the decline took place in just three weeks with the last week being the worst. From late August 1987, highs at +9.4%, which represents the amount the close was above its EMA, it dropped to -26% in early December 1997 (line A). As the chart indicates, over the past twenty years, this seems to be the oversold extreme for the S&P 500. This level was also reached in 2001 (line B) and then about a year later in 2002 (line C) with readings just slightly exceeding -26%. During the decline, in reaction to the minor recession in 1990, the 34 EMA% just reached -10%. The market’s decline was also quite severe in 1998 as the 34 EMA% dropped to -8.6% in 1998.

On the upside, the +10% level has been exceeded many times over the past 20 years but has acted as a kind of ceiling. As is the case with many overbought/oversold indicators, extreme overbought readings do not often pinpoint exact turning points, while oversold readings usually do coincide with bottoms. In fact, extreme overbought readings are often seen at the start of major bull markets, as was the case in the 1995-1997 period when the S&P began its dramatic rally and similar overbought extremes just after the 1982 lows kept many analysts from turning bullish. Divergences between the 34EMA% and prices are often a better indication that a top is being formed. As the S&P 500 continued to make higher highs in 1999-2000 (line 1), the 34 EMA% made lower lows (line 2), suggesting that the market was losing upside momentum. Later in the article, I’ll take a closer look at the S&P during this period.

Figure 2

Figure 2
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The Nasdaq is a more volatile index than the S&P 500, and therefore, one would expect greater extremes in the 34 EMA% readings. The two extremes for the Nasdaq occurred during a two-year period corresponding to the 2000 highs when the 34 EMA% reached +37.8% and in early 2001 at -36.6%. For the rest of the time, the range between -20% and +20% (green lines) held most of the trading. At the 1990 recession lows (line A), the 34 EMA% just exceeded -20%, and during the 1998 drop, the low was -13.8%. On the upside, the first time the +20% level was overcome was in early 1999, as the Nasdaq started to rally aggressively. After a pullback in late 1999 to the +5% area, the 34 EMA% surged to a high of +37.8% that coincided with the March 2000 price highs. In contrast to the S&P 500, no divergences were evident at the highs. Just over a year later, in April 2001, the 34 EMA% had dropped to the -36.6% level, which was indicative of heavy selling. Over the next 18 months, the Nasdaq continued to make lower lows (line 1), while the 34EMA% formed a series of higher lows (line 2). This positive divergence was confirmed in April 2003 (see arrow) when the 34 EMA% resistance (line 3) was overcome, and the 34-EMA turned higher. For the past four years, the 34 EMA% has stayed in a range between -9% and +10%.

Figure 3

Figure 3
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Figure 3 above is an expanded view of the same chart that was featured in Fig. 1. As the S&P 500 was continuing to make higher highs in 1999 and 2000, the closes were a smaller percentage of the 34-EMA, as indicated by the lower highs (line a). The relationship changed in October 2000, as the 34 EMA% broke its support (line b). This reflected the shift from the S&P 500 being above its support at the EMA to being below the now-declining 34 EMA%. For the next three years, rallies in the 34 EMA% back to the zero level (i.e. tests of the declining 34-EMA) helped identify the rallies within the downtrend. In October 2003, the 34 EMA% started to diverge (line c), and the pattern of lower highs in the 34 EMA% (line a) was broken decisively the week of April 17, 2003.

As of early 2008, the previous support in the 34 EMA% in the -2.0 to -2.4% area (line d) has just been broken. This is a potentially troublesome sign as the S&P 500 needs to mount a dramatic rally over the next month or two to reverse this deterioration.

Figure 4

Figure 4
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So does this have trading applications? Though my primary goal was to help identify overbought or oversold extremes that could aid in entering or exiting positions, the daily analysis is different. On the daily data, using the same 34-EMA formula, it responds in a similar fashion as other momentum indicators. Looking at the daily data on the SPY, the 34 EMA% has seen extremes of +5 to -5% but has spent most of the time in the -3 to +3% range. Clearly, this was never conceived as a stand-alone trading indicator, so for trading purposes, I have added in the OBV with its 21-WMA. So, let’s take a look at how these two indicators might be used, with the trigger being a candle formation that suggests a short-term reversal.

The first point I would like to look at occurred on September 12, 2005 (point 1) as a doji was formed. The 34 EMA% was in a downtrend (line a) and had just rebounded from slightly negative territory. The OBV was in a well-established downtrend (line b) and was below its 21-WMA. This favored the short side and the next day’s open was below the prior day’s low which began a seven-day decline. Once again, the 34 EMA% dropped just barely into negative territory before rallying back to slightly above the zero level. This was the optimum selling opportunity with the lower close on October 3, 2005 (point 2). The lower highs and lower lows in the OBV also favored the short side. The SPY declined about 5% in the next eight days ending with a reversal formation on October 13, 2005 (point 3).

With this close, the 34 EMA% dropped below the -3% level, suggesting that the decline might be coming to an end. Although the OBV was still negative at this stage, an order to buy above the high of the 13th would have been filled on the next day’s open. Despite the lack of confirmation by the OBV, entry into the market at this point, backed by the doji and the 34 EMA%, would be low-risk, provided a protective stop was placed below the low. The SPY consolidated and tried to move higher for the next two weeks and on October 31, the 34 EMA% was able to move back above the zero line. Two days later, the SPY closed strong (line A), and the 34 EMA% and OBV both broke their downtrends (lines a and b). The SPY rallied for the next three weeks pushing the 34 EMA% to +3.6% on November 23, 2005 (point 4). The tight range the next day (127.22-126.81) set the stage for a sharp three-day decline. You should note that this was Black Friday, the day after Thanksgiving, which historically trades in a narrow range, but is often ignored.

The SPY managed to consolidate for a week before pushing to new rally highs on December 14th (point 5). The 34 EMA% had formed lower highs, and the SPY’s tight range and lower close the following day signified an end to the rebound, and a deeper, two-week decline ensued. What, if anything, would keep one from expecting a deeper, more serious decline? The OBV had shown no divergences (line d) and pretty much held above its rising WMA during this period. This was a positive sign and suggested that the intermediate trend was still positive. On the last trading day of 2005 (point 6), the range was again tight with the 34 EMA% just below zero and the OBV testing its rising WMA. Strong action on the first day of 2006 moved the 34 EMA% above its downtrend and the OBV closed at new rally highs which favored further gains. On January 11th (point 7), the SPY made convincing new rally highs, but they were not confirmed by the 34 EMA% warning that another correction was possible; however, once again, the strong readings from the OBV kept the intermediate outlook positive.

The relationship of the close to the 34-EMA is something I’ve observed for many years before converting it to a quantifiable indicator. The construction of this indicator may appeal more to some of you than other indicators that I have written about, as moving averages are familiar to most. I have found it to be useful when analyzing weekly mutual fund data as the overbought or oversold extremes can be used to help time switches between funds or in timing new allocations. Just be sure that the data you use is adjusted for distributions.

As always I welcome your feed back on these articles and I can be contacted at tomaspray@intershow.com I would also appreciate any suggestions you may have for future articles.

Tom Aspray, professional trader and analyst, serves as video content editor for InterShow''s MoneyShow.com Video Network. Mr. Aspray joined InterShow full time in June of 2007 where he also does other editorial work for the site, including the bi-weekly trading lessons and the weekly charts to watch. Mr. Aspray has written widely on technical analysis and has given over 60 presentations around the world. Over the years, he has applied his methodologies not only to the stock and commodity markets but also the global markets, mutual funds, and foreign exchange. Many of the technical indicators that Mr. Aspray wrote about in the 1980s, such as the MACD, have since gained worldwide acceptance. He was originally trained as a biochemist but began using his computer expertise to analyze the financial markets in the early 80s. As a consultant, Mr. Aspray wrote daily institutional reports for firms such as Fleming Jardine and Barings Bank and was noted by the Wall Street Journal as one of the "top bond market technicians."

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