oversold Archives - Algorithmic and Mechanical Forex Strategies

The Beginner’s Guide to Short Selling

December 11, 2015 by Lior Alkalay 10 Comments

Short selling is easy, right? Basically, it’s the same as buying, only going the other way. At least that seems to be the common belief when discussing shorts.

In practice, taking a short position is rather simple. However, it’s also utterly different when it comes to an actual strategy. Because, like it or not, shorts do mirror longs, absolutely and completely. And to be a really good short seller, you must know the difference. You must also know how to optimize your strategy specifically toward it.

Short Selling is Fear-based

When you short sell you gain when the instrument you’re trading moves lower. That’s the exact opposite of when you’re long, or a buyer. And that’s where the similarities between long buying and short selling end. You see, when a trader buys or goes long on something they’re betting the outlook for that instrument will brighten. And the instrument doesn’t matter, whether it’s a stock, or a commodity, or even an index like the S&P500.

As a side note, however, the case in forex is a bit different when there are currencies of the same status. For example, say the pair is comprised of the dollar and yen, which are both safe havens. But when it comes to say EUR/USD, EUR/JPY or GBP/USD, shorts on those pairs are still driven by fear.

But when traders sell? Now, notice the nuance, it’s not short sell, i.e. make money from a falling price, but actually selling. When a trader sells a position he or she is doing it out of fear of losing money. And it doesn’t matter if that selling is taking profit or trimming losses, it’s still driven by fear. When you’re short selling you’re basically trying to profit from the fear.

Fear, however, works differently than optimism. You see, fear tends to come and go quickly. You can liken it to a stampede of investors running from a predator.

That’s not speculation; that’s fact backed by years of data. Take a look at some of the harsh short selling events in the chart below. You can clearly see that gains that took more than 8 months to achieve were wiped out in less than 4 months.

Source: esignal

Why is that important to you as a short seller? Because it reveals the exact nature of shorts; quick and abrupt. As such, the strategies warranted for such movements should be designed accordingly. In other words, built to ride on quick and abrupt momentum for a quick gain and then closed. True, there are abrupt moves higher, as well, and matching momentum struggles. Momentum should be in the DNA of every short selling strategy if it is destined to succeed in the “long run.”

Starter Kit for the Short Seller

In order to be a successful investor you must be ready for a high momentum short time span trade. And of course, it’s all relative to the interval you trade. Here are some basic ideas and tools to help you get a sense of a solid short.

Trend exhaustion: When you have a prolonged bullish trend there comes a point when the trend hits a brick wall. The buyers just stop coming and the pair hits resistance. Soon after, those that already hold positions fear the trend is reversing. They quickly liquidate their position which results in a forceful short from the top.

There are countless methods to identify trend exhaustion but here is a rather simple one.

As you can see in the chart below, in this case a stock called Palo Alto, hit the top point of 200. But only when it fell back to 190 it stated to move rather quickly and abruptly down. What happened next was that the trend line was briefly broken. But there is another even more important element here and that is the MACD below. The histogram bars that preceded the correction when the trend was rising were rather moderate. In comparison, look at those created in the other direction when there was a short.

Source: esignal

That clearly indicates that there is fear around 190 which triggered quick selling. A trend has to have at least two attempts before heading lower. Thus, it’s clear that another attempt will have to be made to break the 190.

Since we already know there is fear around this point we can expect a short. Once we reach the neck, the point where the selling started last time, that’s our entry point for a short. That, of course, will need to be closed quickly afterwards.

Overbought: Another basic strategy to capitalize on fear with a short is when a pair is overbought. Once again, there are numerous paths and methods to trade on this but here is a simple one. Looking at the EUR/USD as our example we will need to look for two things. When the pair closes above the price channel on the one hand and the RSI is at an overbought level on the other, the pair is overbought. That means an abrupt short is about to begin.

Source: esignal

Profiting from an Oversold Market

August 25, 2015 by Lior Alkalay Leave a Comment

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.

Source: e-signal

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.

Understanding Overbought and Oversold

February 26, 2015 by Richard Krivo Leave a Comment

If you are cooking something and you check on it and you see that it is “overdone” or “overcooked”, what is your immediate reaction? Exactly. You take the dish out of the oven. Remove it from what caused its current overdone state and the sooner the better.

Too late for our chicken dinner below…

What if your car’s engine is “overheated”? Same deal…you do what it takes to get the engine cooled down. Immediately stop doing what caused the engine to become overheated in the first place.

Given these natural reactions, it is easy to see why the initial and almost immediate move by many newer traders to an “overbought” or “oversold” trading scenario is to do the opposite in that case as well.

They reason that since many buy (long) orders moved price up and pushed the indicator into overbought territory, we must do the opposite and take a short (sell) position. Conversely, if many sell orders caused the price to drop and move into oversold territory we much begin to take long positions. It’s almost as though they expect price to snap back like a rubber band when it reaches these overextended zones.

Well…what is instinctively the proper reaction for chicken dinners and car engines is not necessarily the proper reaction when trading.

It is important to remember that when an indicator goes into the Overbought/Oversold areas, it can remain there for quite some time. Just because the RSI or Stochastics indicator reads overbought for example, does not mean that price action on the pair is like a tightly compressed spring that is going to immediately snap back toward the Oversold area.

Let’s take a look at a historical Daily chart of the NZDJPY pair below for an example of this…

Notice on this chart that when Slow Stochastics went above 80 (in the red rectangle) into the overbought area, price continued to go up for another 780+ pips and Stochastics stayed overbought the entire time. Clearly a trader who went short when it first when into overbought territory would have missed out on a great move. They also would have gotten stopped out of their short position very quickly.

To see an example of where price retreats when Slow Stochastics goes into overbought territory we need to look no further than the area labeled “A” on the chart. In this case the candlesticks around “A”, dojis, spinning tops, shooting star and a hammer, indicate the potential for a pullback.

The point to be made is that either scenario can play out so don’t have a knee jerk reaction to the overbought and oversold areas of an indicator.

Remember…

Only take entry signals from an indicator that are in the direction of the longer term trend.

For example, if the trend has been strong and prolonged to the upside, it stands to reason that the indicator will be in overbought territory since it reflects the bullish push of price action. To take a short position at that point would to trade against the trend and that would be introducing more risk into the trade.

Good trading,

Richard Krivo

RKrivoFX@gmail.com

@RKrivoFX