Is the Market Overbought?

“The Williams %R on the SPY is -6.58 we need a pullback”.

“The Slow Stochastic or %K is 93, definitely overbought”.

“The RSI is nearing 70, get ready to unload.”

I have seen a lot of statements like these lately touting that the market is overbought and needs to pullback or rest, but is it?  To answer that question one needs to know their trading horizon, and then understand how to cut through the noise of the indicators.

Trading Horizon

Whether the market is technically overbought or not can depend on your trading horizon.  Keeping it simple, a text book definition would state that an RSI over 70 is overbought and under 30 is oversold.  Look at the chart in the middle of the page and focus on the the 3 sets of RSI Indicators at the top of the chart.   This is the same indicator calculated over 3 different time periods.  The top set uses the price change over a 14 day period and is the ‘standard’ in most chart packages.  The middle set uses a 5 day period and the bottom a 20 day period.  The first thing to note is that they all have the same general shape, but the shorter the period the more overbought and oversold signals that are generated.  This makes sense.  The market fluctuates daily and if your calculation is skewed to short term changes you will get more signals.  If you are a swing or day trader then you should be more concerned about the very short term and using a 5 day (or even shorter) time period in your RSI is appropriate. If you look at the market weekly and want to be more certain that a longer term trend is going to change then increasing to a 20 day time period is more appropriate.   The second thing to note is that in the current market for the SPY, the 5 day RSI is overbought at 79.20.  This, and other oscillators, on a short term basis are leading to some of these overbought calls.  But the 14 day is just approaching 70 and for the longer term investor stay has some room higher.  So which is right?  They both are.  The day trader needs to be nimble but the longer term investor wants to make sure that the trend is changing before trading.   Customize your indicators to your horizon.

Cut Through the Noise

So the market may be overbought and it may not be, but does it matter?  Another important point is to make sure that you do not blindly follow an indicator without understanding it, understanding what it is telling you and knowing why you are using it.  As an example, looking at the 14 day RSI, used by many traders, if you decided to sell when the RSI became overbought in March this year you would have missed the run from 110 to 120 in the SPY,a 10% move.  A market can remain overbought or oversold for a long time.  Steep sustained moves can get overbought quickly.  Is a fast rising market bad?  Not all the time. Momentum oscillators can be very useful and add a lot to the story, but remember that they are called indicators.  Price is king and the indicators should be used as warning signs.  As an analogy, every time you see a deer crossing sign while driving a deer does not run into the road.  You don’t stop, you keep driving the car.  But knowing that a deer could dart in front of you put’s you on alert.  Use your indicators to raise your awareness, not stop you from the mission.

Trade’m well.

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The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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