Overbought (OB) and Oversold (OS) Conditions
Overbought and oversold conditions refer to a security or a market trading above or below its intrinsic value. Fundamental investors often deploy the price-earnings (P/E) ratios to determine whether a security's overvalued (overbought), undervalued (oversold), or fair value (neutral).
In the technical realm, technical traders often deploy technical indicators such as Relative Strength Index (RSI), Stochastic, and other oscillators to identify overbought and oversold conditions.
With markets declining to new lows, are we there yet?
When will stocks reach oversold levels to warrant a sustainable market bottom?
Relative Strength Index (RSI) Indicator
When Welles Wilder introduced a series of technical indicators in his 1978 book – New Concepts in Technical Trading Systems, the RSI indicator quickly caught the attention of technical-driven traders. Today it remains one of the most popular and widely used technical oscillators.
RSI indicator measures the technical strength or weakness behind price movements over a set period, typically by 9 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. RSI rallies to 70 or higher, signaling an overbought condition and an opportunity to begin to scale out of a long position or entertain a short. On the other hand, when the RSI falls to 30 or lower, it suggests that it may be time to cover a short or open a long position.
New parameters for the RSI Indicator in the current market environment
It has been a long time since Wilder first created the RSI indicator in 1978. The stock market environment today is vastly different from the past. The type of players in the marketplace today is different.
Computerized, electronic trading, algo, high frequency, and quant-driven professionals are influential in the marketplace. The black-box and computer-based algorithms have led to explosive trading volume, greater market liquidity, and higher volatility.
One must not lose sight of the fact that oscillators such as the RSI indicator will face extinction if it fails to evolve in today's fast-changing markets.
In recent years, the RSI indicator performed better by slightly tweaking Wilder's original recommendations. For instance, during primary bull markets, the RSI range for an overbought condition should adjust from 70 to 80-90 or higher. Likewise, the oversold condition should rise from 30 levels to as high as 40-50.
During primary bear markets, the RSI range for an overbought condition should also decline to 55-65, and the oversold level should fall to 20-30 or lower.
Bullish and Bearish Divergences
While applying the new overbought and oversold parameters will better identify overbought and oversold conditions, the RSI indicator and other technical indicators remain most effective when there are visible signs of divergences between the security and the technical indicator.
Divergences, either negative (bearish) or positive (bullish), can alert traders to changes in trend strength and impending trend reversals.
For example, the stock price enters a series of higher highs, but instead, the RSI indicator shows lower highs. A negative bearish divergence occurs, warning of a weakening price trend or an impending trend reversal.
Conversely, 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 a strengthening price trend or an impending rally.
Interpretation of RSI with New OB/OS Parameters
Markets react differently when the primary trend is bullish or bearish, at least from an overbought and oversold perspective. In a powerful rising uptrend or a primary bull trend, the market rarely trades down to the oversold levels (30-40). If it does decline toward oversold levels, it will not stay there for too long. During bull trends, the market will often reach overbought levels (80-90) more frequently and stay at overbought levels for an extended timeframe.
When the market is in a primary downtrend, it is the opposite. The market will struggle to reach the overbought levels (55-65) and will have difficulties staying at overbought levels. Because in a bear market, the primary trend is down, the path of least resistance is down. It is reasonable to adjust the overbought and oversold parameters in the direction of the prevailing trends. After declining toward oversold levels (below 20-30). there is a tendency for the RSI and price trend to transition toward a volatile and choppy sideways trading range environment.
SPX dominant trend and overbought/oversold levels
Since setting an all-time of 4,818.62 on 1/4/22, the dominant SPX trend has been a primary downtrend at 4,433 (Jan 2022 downtrend) and a secondary downtrend channel from Mar 2022 between 3,464 and 3,929. The two downtrends warn of further selling pressure and the potential for a retest of the 3,636.87 (6/17/22 reaction low). Below 3,637 signals a decline to 3,464 (bottom of the downtrend channel).
Pivotal initial resistance is 3,918.5-4,019, coinciding with the 6/10/22 gap-down, 6/28/22 negative outside day, top of the Mar/Apr 2022 downtrend channel, and the 38.2% retracement from Mar 2022-Jun 2022 decline). A convincing breakout extends the summer rally toward a retest of 4,374-4,433, corresponding to the declining 200-day ma and the top of the Jan 2022 downtrend).
From a very short-term trading basis, trading support rises to 3,788.5-3,810 or the May 2022 and 6/30/22 lows and then 3,636.87 or the 6/17/22 reaction low.
When will the SPX Index reach oversold levels, signaling a sustainable market bottom?
Since Nov 2021, the RSI overbought/oversold indicator has also turned negative, as evidenced by a descending triangle pattern. A lower high, currently at 57, suggests RSI and SPX price trends are down trending. There are no signs of positive divergence, implying SPX will trend lower.
Failure of the RSI indicator to clear convincingly above the mid-to-high 50s and SPX to breakout above formidable resistance at 3,918.5-4,019 may end the 6/17/22 oversold rally.
However, a breakout in RSI and SPX resistance zone can also trigger a short squeeze, forcing shorts to cover and attracting sideline trading money to return. Under this scenario, the Jun 2022 oversold rally can sustain into the end of the summer, resulting in SPX challenging intermediate-term resistance at 4,374-4,433.
Although the low-30s or the bottom of the descending triangle can act as initial support, the RSI indicator has traded to as low as 24.02 earlier in the year during Jan 2022 correction.
Will RSI break below support in the low-30s and SPX below 3,636.87 (6/17/22 reaction low), triggering the next SPX selloff toward the low-to-mid 3,000s?
Will this result in another 4-year mid-term election cycle low and the resumption of the May 2013 structural bull?