Too Far Too Fast, 3 Overbought Stocks for Traders

February 5, 2008
David Penn

In our free, daily, before-the-bell trader’s newsletter, Morning Coffee with TradingMarkets (click here
to sign up), we have been warning traders that the exceptionally large number of stocks with low Short Term PowerRatings of 1, 2, or 3 was suggesting that the markets were very overbought and likely to reverse.

The selling we had anticipated has arrived in earnest on Tuesday, with the Dow Industrials down more than 200 points less than 90 minutes after trading began. However, as we noted yesterday in our “Top 10 Reasons Why You Should Trade Stocks” article, markets that move down are just as appealing to traders as markets that move up.
By shorting the weaker stocks that have shown recent strength, traders can get an edge over those traders who are either trying to wait out the downturn or those who are trying, mistakenly in our view, to short strong stocks.

One measure of strength that we have found particularly effective for short-term trading is the Relative Strength Index (RSI). The Relative Strength Index is a technical indicator that has been around for decades, and remains a popular tool among many technical analysts.

We have discovered, however, two key adjustments that can be made to the RSI in order to make it a truly valuable indicator in the short-term. Those modifications were, first, to shorten the RSI from its traditional 14-periods to 2-periods. The second modification was to make the oversold and overbought thresholds much harder to reach by lowering the oversold threshold from 30 to 2, and raising the overbought threshold from 70 to 98.

These two modifications make the RSI a much more discriminating indicator in terms of both the data it uses (only two periods instead of 14) as well as what constitutes an “extreme” (and thus potentially
actionable) RSI value. To put it bluntly, we found the traditional RSI to be entirely too generous in including past data and in characterizing stocks as have “too many buyers” or “too many sellers.”
By both tightening up the swing by reducing the period length ,and making the window of overbought or oversold that much smaller, we found that the stocks that passed this test were more likely to respond to their extremes.

Click here
to read more about our research into the 2-period RSI.

All three stocks below have RSI values of 98 or greater. These stocks also all have Short Term PowerRatings of 1. This makes them some of the least attractive stocks in the short-term for traders, and potentially profitable short sells as well. In addition to their
above-98 RSI values, both Superlex and Consolidated Graphics are up 10% or more over the past five days, another signal of a stock that is overextended, overbought, and vulnerable to reversal.

World Acceptance Corporation
(
WRLD |
Quote |
Chart |
News |
PowerRating). RSI(2) 99.23