What statistics say about the market’s next move
After the quick move up at the end of last week,
the market quietly digested its gains today with a slight pullback on low
volume. The overall action remains constructive.
I have received a large number of questions
lately about the overbought condition of the market. Many readers know one
indicator I use to measure overbought/oversold and anticipate reversals in the
market is the VIX. They have correctly pointed out that the recent stretch in
the VIX has failed to trigger a pullback in the market. This observation really
speaks to the usefulness of overbought/oversold indicators.
Everyone knows that overbought can become more
overbought and oversold can become more oversold. So when are
overbought/oversold readings truly useful, and when should they be questioned?
What most traders fail to understand is the significance of the longer-term
trend when evaluating short-term overbought/oversold readings. Without putting
overbought/oversold into the context of the long-term trend, the reliability and
significance of any of these indicators is greatly diminished.
To illustrate this point I will look at the
historical price action under 4 different market conditions:
1) An overbought market in a longer-term
uptrend (like we’ve been seeing)
2) An overbought market in a longer-term downtrend
3) An oversold market in a longer-term uptrend
4) An oversold market in a longer-term downtrend
What you will see is that the best opportunities
to enter the market in anticipation of a reversal occur under scenarios #2 and
#3. Scenarios #2 and #3 are conditions where the market has become short-term
extended in a direction opposite the long-term trend. In most cases, this will
lead to at least a short-term reversal back to the primary trend direction.
Under scenarios #1 and #4 the market has become extended in the same direction
as its primary trend. A reversal in this situation is not nearly as certain nor
as profitable.
Rather than show another VIX study, I thought I
would use a more common indicator which is based solely on price. Price
indicators can easily be tested on any market or security you trade.
Wilders Relative Strength Index “RSI†is a rate
of change oscillator that basically compares the price of a security to itself
(rather than to other securities like Investors Business Daily Relative Strength
numbers do). RSI may show values of between 0 and 100. High readings indicate
a security is overbought while low readings indicate an oversold condition.
Most traders use 70 and 30 as their primary overbought/oversold levels with a
14-period reading.
For purposes of this example I decided to run the
tests on the S&P 500 Index. Since the S&P 500 is a broad index and is less
volatile than individual securities, I narrowed the overbought/oversold levels
to 60 and 40. This helped to provide a larger sample set.
For testing purposes I simply determined whether
the market was in a long-term uptrend or downtrend by where it was trading in
relation to its 200-day moving average. If the S&P 500 was above its 200-day
moving average, it was deemed an uptrend. If it was below it, then it was
deemed a downtrend. While this may be overly simplistic, it is good enough for
purposes of this demonstration.
In every case the test would enter the market in
anticipation of a reversal once RSI gave an overbought/oversold reading and then
close out the trade 5 days later. Tests were run on 20 years of data.
Now let us look at the tests.
Scenario #1 (Overbought in an uptrend)
Conditions for entry:
1) RSI > 60
2) S&P > 200 day moving average
Short the S&P at the close and cover 5 days
later.
Scenario #2 (Overbought in a downtrend)
Conditions for entry:
3) RSI > 60
4) S&P < 200 day moving average
Short the S&P at the close and cover 5 days
later.
Results for Scenario #1 and Scenario #2
As you can see, trying to trying to short an
overbought but uptrending market would have been a futile, money losing
strategy. Using higher RSI readings under Scenario #1 would not have improved
results, either. Even with readings of 65 or 70, the market rose more often
that it fell and would have cost short-sellers money. On the other hand,
shorting an overbought market in a long-term downtrend would have produced
significantly positive results.
Scenarios #3 and #4 look at oversold market
conditions:
Scenario #3 (Oversold in an uptrend)
Conditions for entry:
5) RSI < 40 6) S&P > 200 day moving average
Buy the S&P at the close and sell 5 days later.
Scenario #4 (Oversold in a downtrend)
Conditions for entry:
7) RSI < 40 8) S&P < 200 day moving average
Buy the S&P at the close and sell 5 days later.
Results for Scenario #3 and Scenario #4
Like the first group of tests, the contrast here is obvious. Buying a market
that is short-term oversold in a long-term uptrend can be extremely rewarding.
Not only was the percent winners very high, but the gains outsized the losses by
over 7:1. Buying an oversold market in a downtrend was profitable, but barely.
And probably not worth the effort with such a small profit factor and average
gain per trade.
It is important to note that the above tests are
not tradable systems. They do not take into account such important factors as
risk management and position sizing. Commissions and slippage were also not
taken into account.
To help put the odds squarely in their favor,
traders looking to utilize overbought/oversold indicators to time reversals need
to keep the longer-term trend in mind. Failure to do so can greatly reduce or
even eliminate their edge. As shown above, the best opportunities typically
occur when the reversal trade coincides with the long-term trend. This concept
is not just true of RSI readings, but of most indicators that measure
overbought/oversold levels. Because of this, some of the most successful
reversal traders focus solely on buying oversold markets in uptrends and
shorting overbought markets in downtrends. By only trading when there is a
definable edge, they are able to more consistently produce profits. And
consistently producing profits is what it is all about.
Feel free to email me should you have any
questions.
Best of luck with your trading,
Rob Hanna
For those who may be looking to expand their
knowledge beyond just market timing, my
Hanna ETF Money Flow System utilizes the VIX in generating trading
signals for spread trades.
Rob Hanna is the principal of a money
management firm located in Massachusetts. He has spent the last several years
developing and refining methods for trading in stocks across multiple time
frames. He selects stocks using both fundamental and technical criteria, and
then trades them using technical analysis techniques.