Overbought/Oversold Overload

Analysts love to show off by proclaiming that the markets have become overbought or oversold. Unfortunately, few of us seem to understand what these terms really mean or what we should do when these moments of truth arise.

Should we run for the hills because a market is overbought, or perhaps load up the boat because it's oversold? And how do we know when one of our trades might fall prey to one of these extreme conditions?

The best way to understand overbought or oversold markets is to study the nature of supply and demand. At any given moment, a finite pool of buyers and sellers is available to take action on a particular stock. The trading activity of this crowd usually stays within fairly narrow boundaries.

But imbalances develop over time and force one side to pull the trigger, sometimes prematurely. This "uses up" that side of the market and awakens price mechanics that favor the other side.

Bollinger Bands offer an effective tool for measuring overbought/oversold conditions. Notice how Nvidia (NVDA:Nasdaq - news - commentary - research - analysis) triggers a short-term reversal each time price bars thrust outside the extremes of the 20-day Bollinger Bands. These outer bands tell swing traders to expect a reversal before real evidence appears on the price chart. This allows them to take high-profit exits while the rest of the crowd is caught in the moment.

It's important to note that overbought/oversold markets are relative to a trader's time frame. In the NVDA chart, some reversals were simple pullbacks in the underlying trend, while others represented major market turns. It is vitally important for traders to define their holding period before reacting to short-term price swings. Major profits will be lost by planning the trade in one time frame but executing it in another.

Stochastics represents the classic overbought/oversold oscillator. Unfortunately, most traders don't understand how to interpret the information it provides. The worst thing you can do is jump ship just because stochastics hits a high or low extreme. Most swing-trading profits are booked in the early stages of overbought or oversold markets. Of course, that's where most of the risk is as well.

Use simple double-top or double-bottom patterns to pinpoint reversals driven by overbought or oversold conditions. The best signals come when stochastics makes a lower high (or higher low) and expands in the opposite direction. This type of pattern will often complete ahead of price change, and should be acted upon without waiting for further confirmation.

A single price bar can change everything. Stocks trade with an average high-low range through most market conditions. When this range expands sharply after an extended trend, it issues a loud overbought-oversold signal.

What exactly does this mean? First off, when a price bar expands in a new breakout, it's the beginning of something and not a reversal signal. But when a stock ramps from one price level to another, and then pops an expansion bar, get ready to close up shop in a hurry.

Traders must deal with the relativity of overbought/oversold markets. A longer-term Wilder's relative strength index (RSI) really drives home this vital point. It captures broad cycles of market movement, and it can stay at overbought or oversold levels for extended time periods.

As with the stochastics indicator, hold your ground until RSI shows definite signs of moving in the other direction. This usually comes when it drops below (lifts above) the extension line. Even then, compare RSI with the price pattern to determine whether a major turn, or simple pullback, is under way.