We’ve seen markets butchered by selloffs bleeding red all over the screens. The sense of a looming Armageddon echoes in the news with danger lurking in the shadows. And when the experienced trader sees all that red he begins to twitch with that natural trade reflex. That is the reflex that he or she must trade on the rebound. After all, oversold markets create big rebounds, right? Certainly, they can. And this is why, today, our focus is on how to trade a rebound after an aggressive selloff.
Signs of an Oversold Market
I’ve heard it said, and I fully agree, that the market can be likened to a rubber band. It stretches and stretches until it reaches its maximal elasticity. Then, given its natural tendency, it shrinks back. In this particular case, we’ve got an oversold market, i.e. it’s stretched like a rubber band. But how do we know that it’s nearly reached its maximal elasticity, and that it’s ready to shrink back?
There are, of course, many methods to identify this maximal stretch. Everyone is entitled to a personal favorite; mine is a combination of two indicators which I believe work best for short term rebounds. It is the combination of an indicator known as the Rate of Change (ROC) and the ever popular Bollinger bands as an overlay.
Combining Rate of Change and Bollinger
Rate of change is essentially a very simple straight forward index. It measures the percent of change from the n periods before. The Rate of Change is exactly what we need. Especially in indices trading, it’s pretty much a given that after a certain percent change downwards there’s a fairly automatic buy reflex. There are a number of fundamental reasons why that happens, but they’re irrelevant to this discussion. The main takeaway of this focus, the benefit of the ROC, if you will, is that it happens.
In the chart below, we have an ROC running on 10 days. After a certain rate of decline (in percent), markets rebound. The problem is that it’s still hard to tell when we’ve reached our maximal elasticity to time the rebound. For that we need to overlay the Bollinger band (which works on two standard deviations that are ideal for identifying the maximal elasticity). With the ROC/Bollinger overlap, we get an indication as to when the downwards ROC is too much, i.e. the signal that markets need to shrink back. What we’re looking for is when the ROC is outside the Bollinger band. That’s our signal for an oversold market ready to rebound.
Low vs Closing Price
I can’t stress enough how timing is of the essence when it comes to trading an oversold market. Therefore, some validations are needed to ensure your timing is, indeed, correct and that the selling momentum is over. From personal experience, my validation or cue is a candle with a long needle, which signifies a large gap between the session low and the closing price. What that all means, essentially, is that the market is running out of sellers. When it comes in tandem with our ROC signal, it’s a sign of an oversold market ready to rebound. That, of course, is our entry signal.
A Few Good Rules of Thumb
Before you begin to test this strategy on an oversold market, let me leave you with a few ground rules. From personal observations, the best time frame to use the ROC is daily. An hourly time frame is too fast and the ranges are unreliable. A weekly range can be much deeper and the movements slower. When it comes to the best interval, I’ve found the ROC running on 10 days and the Bollinger band that overlaps running on 20 days to be ideal. Of course, it’s best to experiment on your own to calibrate it as you see fit.
Finally, and very importantly, place a reliable stop loss. Usually, the support zone will be rather evident; in the case above it is roughly at 180, where the market rebounded before.