There is a lot of talk about this market being overbought. There’s just as much talk about how many investors aren’t in this rally and they want in. Let’s start the talk for those that ARE in this market – what now? What are some signs to watch out for? Are you day-trading in and out of positions? Why not let those winners run? Here are some guidelines to help let those profits run in a trending environment.
Oscillators vs. Moving Averages
Oscillators are indicators that fluctuate between extremes and are best used when a security is trading within an identifiable range. When a trend has formed, oscillators can remain at extreme levels for an extended period of time. That is why they are not the best indicator to follow while a market is trending. A better indicator to follow in a trending environment is the moving average along with other indicators of the same ilk such as the Bollinger Bands and the Parabolic SAR.
Oscillators
Banded oscillators, such as RSI and Stochastics, are telling investors that the stock market is overbought right now. What does that mean? RSI and Stochastics are indicators that are bounded from 0 to 100. A reading can never go below 0 and can never go above 100. When the RSI reads above 70 a security is considered overbought. When a stochastic reads above 80 a security is considered overbought. Below is a chart of the S&P 500 along with both the RSI and the Slow Stochastic.
If you look at the chart above, this market has been overbought for some time – Since July 23rd for the RSI and since July 17th for the slow stochastic indicator. The stochastic indicator has been overbought for 11 trading days! Trending markets can remain in overbought territory.
Moving Averages
Moving averages smooth a series of data over a specified period of time. The shorter the time period, the more sensitive the moving average and the more “noise” it can create in volatile markets. Moving averages are the foundation of other technical indicators such as the Bollinger band. Because moving averages smooth out the data, it makes it easier to tune out some of the noise and identify the direction of the trend. The only problem with a moving average is that it has a lag due to the average calculation. Exponential averages attempt to eliminate some of this lag by weighting near-term data with a higher priority.
Moving averages follow a trend. They are one of the best places to go to find that a trend is changing. When a moving average is rising, the trend is up. When it is falling, the trend is down. So it is that following the moving average can help us follow the trend. In the case of the S&P 500, a chart below shows two widely used moving averages, the intermediate-term 50-day moving average and the short-term 20-day moving average.
From December 2008 to March 2009 the (blue) 50-day moving average (DMA) was declining. It turned flat in April and has been climbing (confirming an uptrend) since May 2009. A noisier, but faster turning short-term moving average is the 20 DMA (yellow). The 20 DMA turned up in March almost a full month and a half before the intermediate trending 50 DMA. At this moment in time, both your short-term and intermediate-term DMAs are moving higher confirming an uptrend.
Advanced Strategies
Other helpful trending indicators are the Bollinger Bands and the Parabolic SAR. Bollinger Bands contain an upper and lower band set to 2 standard deviations around a simple moving average. The upper band is 2 standard deviations higher than the moving average and the lower band is 2 standard deviations lower. Periods of low volatility are identified by tight bands around the moving average. Periods of high volatility are marked by very wide bands around the moving average. There is a tendency to move from one mode to the other.
For the current S&P 500 index chart, what we’re looking for is a top signal. This can happen a number of different ways but here are three steps in the process to watch out for:
- Price breaks above the upper band
- Price fails to break above the upper band on a second peak
- Confirmation with a break below the 20 DMA (middle band)
The current situation shows that we broke above the upper band in July and we’ve come back inside the upper channel. If price fails to break above the upper band on a subsequent peak, it will be our second sign of a possible correction. Confirmation would then be given with a break below the 20 DMA (middle band).
The Parabolic SAR can also be helpful in identifying the end of a trend. The Parabolic SAR creates a trailing stop below an upward trending market and above a falling market. Buy and Sell signals are triggered when the price moves through the Parabolic SAR. When a signal is created, a new trailing stop is created in the opposite direction. The indicator is not as widely used to determine trend as it is to help identify a stop to get out of the market (or in). Here are some of the signals given by the Parabolic SAR this year.
Conclusion
There is no black box to investing. There’s no magic indicator that will solve all your timing needs. Technical analysis is about using all of the pieces of the puzzle to determine what the picture of the puzzle is. The tools above are useful tools when used together to piece the clues that momentum and psychology can give us on the puzzle. 1000 is a key psychological barrier in itself and is just another piece of the puzzle. The market is overbought, yes, but that in itself is another piece of the puzzle. No individual piece can stand alone as a proxy to this puzzle. While the market is trending, there are few more useful indicators to watch here other than just the oscillators. Look to the moving averages, Bollinger Band, and the Parabolic SAR for some helpful indicators that will allow you to let your winnings run. Don’t get too overexcited and allow 1-3 bad days to make you jump ship just because this market is overbought.
