Overbought (OB) an Oversold (OS)
Overbought and oversold conditions refer to a security or a market that is trading at a level above or below its intrinsic value. Fundamental investors will often use the price-earnings (P/E) ratios to determine whether a security is trading at overbought (overvalued) or oversold (undervalued) levels. In the technical realm, technical traders and investors will often deploy technical indicators such as Relative Strength Index (RSI), Stochastic, and other technical oscillators to analyze overbought and oversold conditions.
With markets setting new all-time highs daily, the question that comes up is the market finally trading at overbought levels?
What is the Relative Strength Index (RSI) Indicator?
When Welles Wilder first introduced a series of new technical indicators in his 1978 book – New Concepts in Technical Trading Systems, the RSI indicator quickly caught the attention of many technical-driven traders and investors. Many years later, it remains popular and widely used momentum oscillators.
RSI indicator measures the technical strength or weakness behind price movements over a set period, typically 9-periods or 14-periods, using the following formula: RSI = 100-100/(1+RS). RS represents the ratio of the average upward moves to downward moves over a specified timeframe.
In Wilder's work on the RSI indicator, he defined a level from 0 to 100 and assigned 70 for overbought and 30 for oversold. Traders and analysts learned that when the RSI rallies to 70 or higher, it is an opportunity to begin to scale out of a long position or to entertain a short. When the RSI declines to 30 or lower, it represents a time to cover a short or open a long position.
Need to Adapt the RSI Indicator to the Current Market Environment
A lot has changed since Wilder first created the RSI indicator in 1978. The stock market environment today is vastly different from the extended range-bound trading range trends of the past. The type of players operating today is also not the same. Today, computerized, electronic, algo, high frequency, and quant-driven trading outfits dominate the marketplace. These black-box driven, automated, and computerized trading systems have led to explosive trading volume, more liquidity, and greater market volatilities.
One must not lose sight of the fact classic momentum oscillators such as the RSI indicator will face extinction if it fails to evolve with today's fast-changing market environment. In recent years, it appears the RSI indicator performs better when you slightly tweak Wilder's original recommendations on its use.
For instance, during primary bull markets, the RSI range for an overbought condition should change from the original 70 levels to 80-90. Also, the oversold condition should rise from 30 to 40-50. During primary bear markets, the RSI range for an overbought condition should decline to 55-65, and the oversold level should fall to 20-30.
Bullish and Bearish Divergences
While applying the new overbought and oversold ranges will help better identify overbought and oversold conditions, the RSI indicator and other technical indicators are most effective when there are visible signs of divergences between the security and the technical indicator. Divergences, either negative (bearish) or positive (bullish) can be powerful technical signs of impending trend reversals. For example, the stock price creates a series of higher highs, but the RSI indicator shows lower-highs. The divergence is commonly referred to as a bearish negative divergence and warns of an impending trend reversal. On the other hand, a positive bullish divergence occurs when the stock price or market index creates lower-lows, but the RSI shows a series of higher lows. The action hints at an impending rally.
Interpretation of RSI with New OB/OS Parameters
Markets react differently when the primary trend is bullish or bearish, at least when it relates to overbought and oversold conditions. In a powerful rising uptrend or a primary bull trend, the market will rarely trade down to the oversold levels (30-40). If it does manage to decline toward the oversold levels, it will not stay at these levels for too long. On the other hand, during bull markets, the market will often reach overbought levels (80-90) more frequently and stay at overbought levels for an extended timeframe without signaling a market peak.
When the market is in a primary downtrend, it is typically the reversal. The market will rarely trade toward the overbought levels (55-65) in any meaningful way and will have difficulties sustaining at the overbought levels. Because the primary trend is down in a bear market, the path of least resistance is down. After declining toward oversold levels (20-30) there is a tendency for a transition to either tight trading ranges or feeble attempts at very short-lived technical rallies.
Is the market (SPX) currently Trading at Overbought Levels?
The 1-plus year chart of the S&P 500 Index (SPX) shows several interesting technical developments. The negative divergence (bearish) between the RSI indicator and the SPX price during Jan-Feb 2020 forewarned of the 35.41% COVID-19 pandemic market sell-off. However, since the 3/23/21 bottom, the primary bull trend appears to be gaining technical strength despite the unprecedented 78.44% rally so far. Although most deploy the RSI indicator to help identify overbought/oversold conditions, RSI can also be great at determining the underlining strength of the primary trend. Since the March bottom, two overbought readings (June and Sep 2020) show persistent, lengthy, and sustainable overbought readings. Both technical conditions are hallmarks of a strong, healthy, and longer-lasting bull trend. Despite the impressive March to Sep 2020 gains, there were also no visible oversold conditions that developed during this timeframe. Again, this is another technical sign of a sustainable primary bull market. Another important point worth mentioning is when oversold conditions developed during late-September to October 2020 as the RSI declined briefly to 35-37 it quickly rebounded, further reinforcing the resiliency and inherent strength of the primary bull trend.
The question then remains – is the SPX Index currently trading at overbought levels as so many are alluding to? Since late last year to early 2021, as SPX recorded new record highs, the RSI indicator has failed to reach the heightened overbought levels of June and Sep 2020, and most importantly it has failed to generate any meaningful declines in both the RSI indicator and the SPX price chart. Based on the above observations, although minor corrections cannot be ruled out, SPX is not yet trading at extreme overbought levels (80-90) to warrant the start of an extensive and deep correction.