Wednesday, September 12, 2007

Overbought, Oversold, and Oscillators

Overbought and Oversold

Many pundits out there throw out the words overbought, and oversold when it comes to stocks or the major stock indices. Is there a way to keep track of overbought and oversold?


There are many technical indicators (special indicators by looking at the stock charts) to help determine oversold and overbought conditions. Oscillators are the most popular. At one point, a stock (or index) is overbought, and then at another point, it oscillates back to oversold.

S&P Oscillator

One popular Oscillator is the S&P (Standard and Poors) Oscillator, which is a proprietary Oscillator. In Jim Cramer's 'Real Money: Sane Investing in an Insane World', Jim Cramer mentions the proprietary S&P Oscillator as one way to spot a market bottom. He says that it costs around $1000 to subscribe.

On Jim Cramer's site, Jim Cramer Says:

"When the oscillator is over five, people must sell, regardless of how great it looks," Cramer recommended. "There have been some [times] where the animal spirits of the market have been so great that it's gone to plus nine and 10, but the percentages on the upside are that there's going to be a selloff. It may not be major, but I do believe it will happen."

When it's over five, if he were fully invested, Cramer said he would cut to being 75% invested. At this time, short-term traders should maybe go 50% invested, and "if you're a guy who is able to short, maybe 25% short," he said. "That's how much I have faith in this indicator. I have faith in almost no indicators other than this one.

"Helene Meisler, [a contributor to does] her own oscillator work," Cramer said. "She seems to agree with me on the site. When we both agree, we tend to have a pretty powerful correlation between right and wrong."

RSI Oscillator

For more inexpensive ways to determine oversold/overbought, one can use the RSI indicator. RSI stands for Relative Strength Index. When the RSI is over 70, the stock or index is overbought. When the RSI is under 30, the stock or index is oversold.

Of course, stocks or indices can remain oversold or overbought for long periods of times:

In the above example with Garmin (Chart of GRMN with RSI information here), we notice that when RSI is in overbought territory, GRMN is near its high, and when RSI is in oversold territory, GRMN is near its low.

Towards the middle of 2007, we do notice that GRMN remains in overbought territory, but GRMN makes very good gains during this time. This is an example of an overbought situation remaining overbought for long periods of time. The same can happen with oversold stocks or indices. Some technicians suggest to wait till the RSI goes down below 70 after remaining overbought, or wait for RSI to go up above 30 after remaining oversold.

Other Oscillators

There are many other oscillators as well such as using Bollinger Bands, or Stochastics. TradingDay has a good link to some of these oscillator methods.

Bottom Indicators

There are many other bottom indicators as well. Some oscillators above may be more suitable for traders and short term traders. But if one wants to find more long term investable bottoms, you can use some of these other methods:

  1. S&P 500 Stocks Above the 50 and 200 Day Moving Average (Low value = Bottom)
  2. S&P 500 High-Low Index (Low Value = Bottom)
  3. 10 Day Moving Average of Put-Call Ratio (High value = bottom)
  4. Ratio of Stocks Above 200 Day Moving Average to Stocks Above 50 Day Moving Average
  5. Bull-Bear Ratio and Bullish Percentage
  6. Index in Relation to 52 Week High and 52 Week Low

You would like to look at several of the different indicators and look at the support and resistance levels of a particular stock or index.

1 comment:

Matthew said...

I'm a forex trader, but we use the same indicators and strategies. Let me recommend using moving average with envelopes (standard deviation). It involves more tweaking due to market volatility, but I find them much more effective than RSI or Stochastic.