When Do Overbought Stocks Simply Become More Overbought?
Want to know the biggest secret about technical indicators?
Sometimes stocks that become overbought don’t do anything more than become more overbought.
Just about everyone who has ever used an oscillator, which measures the degree to which a market has moved above or beyond a certain extreme, has realized this. But few people have approached this reality in a systematic fashion. What does it mean, practically speaking, that many–if not most–overbought stocks simply become move overbought?
In one sense, it means selling stocks just because they are “overbought” in a traditional sense can be a failed strategy. If you do not believe me, then take a look at any strong bull market in recent history.
What you’ll find is likely a market that became overbought and stayed that way for session after session after session, moving higher and brutalizing the short sellers every step of the way.
Part of this is simply the nature of bull markets, that become more overbought as increasing numbers of those on the sidelines begin to “buy in” to the market.
But part of this has to do with the failure of technical indicators that keep the bar for “overbought” conditions far too low. With it so easy for stocks to become overbought using traditional, default values, many of these indicators are worse than useless for short-term stock traders. In fact, they can often be used in the exact opposite way that they were intended to be used–i.e., buying stocks when they become overbought rather than selling them.
One of the things that has been so effective in the changes we have made to an indicator like the Relative Strength Index has simply been to raise the bar for overbought conditions. We moved overbought “threshold” to a level where we have found quantitative evidence that the stocks in question are truly OVERbought and more likely to reverse.
By raising the overbought threshold from the traditional 70 to our modified 98, we find ourselves looking only at the most extremely overbought stocks, the stocks that have truly moved too far too fast–as opposed to those stocks that are merely quick on their fee. These are the stocks that, when caught at the right time, are the kinds of stocks that traders can confidently bet against, making money as savvy traders are taking profits and panicked traders are desperately trying to sell.
That “right time” is when those stocks are trading below their 200-day moving averages. While overbought is overbought, there is simply no reason to try and bet against strong stocks. Indeed, strong stocks are the stocks that are most likely to become overbought and stay that way. But overbought stocks that are truly weak stocks, stocks that are trading below their 200-day moving averages, are precisely the sort of stocks that are most vulnerable to reversal when they become overbought–truly overbought.
Here are four “truly overbought” stocks that Short Term stock traders should keep an eye on. All four have 2-period Relative Strength Index values of more than 98–and are trading below their 200-day moving averages. This makes them among the most precariously overbought stocks in the market right now. To read more about our research into trading stocks using the 2-period RSI, click here.
LifePoint Hospitals
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Micrel
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Steris Corporation
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Superior Industry International
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David Penn is Senior Editor at TradingMarkets.com.