Determining overbought and oversold levels by Darren Winters
Following on from the article about the use of candlesticks, we thought it was appropriate that we should accompany that article with this. Overbought and oversold indicators can be extremely useful when used in conjunction with reversal patterns in candlesticks.
If a candlestick is showing a clear reversal pattern, weight can be added to its validity if the equity is also at an extreme in price. By looking at such indicators and knowing when they are overbought or oversold, we can also be more confident of any trades that we are looking to place, whether they are buys or sells.
There are four main indicators that we use to determine if a stock or index is at overbought/sold levels. These are Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), Rate of Change (ROC) and Stochastics.
RELATIVE STRENGTH INDEX
Wilders RSI compares an equity’s performance against itself over a period of time. It should not be confused with ‘relative strength’ which is the comparison of one equity’s performance to another.
It is a price following oscillator that ranges between 0 and 100. Not only is it good at showing overbought/sold readings, but it can show divergences too. Generally speaking, RSI tops when it gets above 70 and bottoms when it gets below 30.
You can use any number of different settings for RSI we often use a period 21, average 1.
RATE OF CHANGE
ROC displays the difference between the current price and the price X number of periods ago. The 12 period rate of change is very good as a short to intermediate term overbought/sold indicator. This 12 period setting tends to be very cyclical, oscillating in a fairly regular cycle. This enables you to place greater emphasis of a coming change in stock prices. Again, this doesn’t have to be your setting as everyone has different trading practices.
With this indicator, the higher the ROC, the more overbought the equity is and the lower the ROC, the more likely it is to rally. As with all indicators, wait for the market to change before entering a position. One word of warning with this indicator, when it is at absolute extremes, this could imply a continuation of the trend that is already underway.
MACD
MACD is a trend following momentum indicator. It shows the relationship between two moving averages of prices. This indicator is also useful for determining overbought and oversold levels.
Although we like plotting this indicator as a histogram, it should also be used as a line graph so that extreme levels can be seen. A setting that is often used for this indicator would be 5,35,5 although we tend to use others to accompany this.
STOCHASTICS
Stochastics compares where price has closed relative to its range over time. The stochastics oscillator is displayed as two lines; the main line is called the %K and the second line is called the %D. This second line is a moving average of the %K line.
Similar to RSI, stochastics has specific levels to indicate when an equity is overbought and oversold. These are above 80 and below 20. Generally, when the indicator moves below the 20 range and then moves back above it, that indicates a buy signal. The reverse is true when it passes through the 80 range.
Similar to RSI, stochastics can also be used to detect divergences. For instance, if price is rising but stochastics fail so surpass their previous highs, then that could be a sign of future stock weakness.
CONCLUSIONS
Using a combination of indicators can certainly help determine when a stock or index is at overbought or oversold levels. However, this is not necessarily enough to be able to gain an exact entry or exit point.
However, if using other reversal indicators like candlestick patterns in conjunction with these, then your trading can become much more effective. For example, a classic doji formation on a daily candlestick would not automatically mean a trade should be placed. But if that doji came in conjunction with overbought/sold readings from other indicators, then it can add much more conviction regarding it viability.
If you have seen a reversal pattern on a candlestick chart that is in conjunction with the readings in your indicators, you should still wait until the following day to ensure that the reversal pattern is correct before entering the trade.
It should be noted that all indicators, however good, can and do fail from time to time. It is for this reason that we always use a number of indicators and chart patterns in order for us to build a better picture of the future direction of a stock.
Darren Winters
If a candlestick is showing a clear reversal pattern, weight can be added to its validity if the equity is also at an extreme in price. By looking at such indicators and knowing when they are overbought or oversold, we can also be more confident of any trades that we are looking to place, whether they are buys or sells.
There are four main indicators that we use to determine if a stock or index is at overbought/sold levels. These are Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), Rate of Change (ROC) and Stochastics.
RELATIVE STRENGTH INDEX
Wilders RSI compares an equity’s performance against itself over a period of time. It should not be confused with ‘relative strength’ which is the comparison of one equity’s performance to another.
It is a price following oscillator that ranges between 0 and 100. Not only is it good at showing overbought/sold readings, but it can show divergences too. Generally speaking, RSI tops when it gets above 70 and bottoms when it gets below 30.
You can use any number of different settings for RSI we often use a period 21, average 1.
RATE OF CHANGE
ROC displays the difference between the current price and the price X number of periods ago. The 12 period rate of change is very good as a short to intermediate term overbought/sold indicator. This 12 period setting tends to be very cyclical, oscillating in a fairly regular cycle. This enables you to place greater emphasis of a coming change in stock prices. Again, this doesn’t have to be your setting as everyone has different trading practices.
With this indicator, the higher the ROC, the more overbought the equity is and the lower the ROC, the more likely it is to rally. As with all indicators, wait for the market to change before entering a position. One word of warning with this indicator, when it is at absolute extremes, this could imply a continuation of the trend that is already underway.
MACD
MACD is a trend following momentum indicator. It shows the relationship between two moving averages of prices. This indicator is also useful for determining overbought and oversold levels.
Although we like plotting this indicator as a histogram, it should also be used as a line graph so that extreme levels can be seen. A setting that is often used for this indicator would be 5,35,5 although we tend to use others to accompany this.
STOCHASTICS
Stochastics compares where price has closed relative to its range over time. The stochastics oscillator is displayed as two lines; the main line is called the %K and the second line is called the %D. This second line is a moving average of the %K line.
Similar to RSI, stochastics has specific levels to indicate when an equity is overbought and oversold. These are above 80 and below 20. Generally, when the indicator moves below the 20 range and then moves back above it, that indicates a buy signal. The reverse is true when it passes through the 80 range.
Similar to RSI, stochastics can also be used to detect divergences. For instance, if price is rising but stochastics fail so surpass their previous highs, then that could be a sign of future stock weakness.
CONCLUSIONS
Using a combination of indicators can certainly help determine when a stock or index is at overbought or oversold levels. However, this is not necessarily enough to be able to gain an exact entry or exit point.
However, if using other reversal indicators like candlestick patterns in conjunction with these, then your trading can become much more effective. For example, a classic doji formation on a daily candlestick would not automatically mean a trade should be placed. But if that doji came in conjunction with overbought/sold readings from other indicators, then it can add much more conviction regarding it viability.
If you have seen a reversal pattern on a candlestick chart that is in conjunction with the readings in your indicators, you should still wait until the following day to ensure that the reversal pattern is correct before entering the trade.
It should be noted that all indicators, however good, can and do fail from time to time. It is for this reason that we always use a number of indicators and chart patterns in order for us to build a better picture of the future direction of a stock.
Darren Winters
posted by Darren Winters at 12:18 PM
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