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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.

Oversold Market

 

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.

Filed Under: Trading strategy ideas Tagged With: bollinger band, oversold, rate of change

Determining Trend Direction

July 11, 2013 by Andrew Selby Leave a Comment

Most of the systems I have profiled produce the best results when the markets they trade are trending. Because of this, I often suggest adding a filter to these systems to make sure that they only trade markets when they are trending. This will allow our systems to trade freely when conditions are most favorable, and sit on the sidelines when conditions are not favorable.

The Simplest Method

The most common way to determine trend direction is using the 200 unit simple moving average (SMA). I often recommend using the SMA to determine trend because it is extremely simple to understand. If the price is trending above the SMA, you are free to place long trades. If the price is trending below the SMA, you are free to place short trades. This ensures that you are never attempting to swim against the powerful current of the market.

I recently read an article that tested the SMA against three other indicators to determine which was best able to determine trend direction. While the SMA did perform respectably well, it was overshadowed by the very impressive performance of the Rate of Change (ROC) indicator.

The results of the comparison showed that using ROC to assess trend direction resulted in less changes in trend than using SMA. This lead to much smoother trading and less whipsaws. One thing I found curious was that the article only tested long-side trades. It did not discuss how ROC and SMA might compare on the downside.

Using ROC To Determine Trend Direction

ROC is on the same level as SMA in terms of simplicity. All it does is determine the percentage that a given market is up or down over a certain amount of time. The recommended time values for ROC are 14 for short term trading and 25 for longer term trading. Since we are just using ROC to determine trend direction and not to time trades, we will use a time period of 200 to match our SMA.

This is the formula for ROC:

Rate of Change =

(Current Price – Price N Periods Ago) / Price N Periods Ago

This formula will give us a percentage that the market is either up or down over a specified time period. The more a market is up, the stronger the trend. However, for the simple task of determining trend direction, we can simply say that a positive number represents an uptrend, and a negative number represents a downtrend.

A Recent Example

The current daily chart of Microsoft (MSFT) provides a great example of how similar these trend indicators are. As you can see, MSFT broke above its 200 day SMA line at the end of March. Its 200 day ROC line confirmed this new uptrend when the price really started to move towards the end of April. Since then, both the SMA and ROC have indicated that the stock is in an uptrend.

Determine trend SMA ROC

Determine the trend direction for MSFT using an SMA and ROC.

The ROC slightly lags the SMA because it is based on price movement, rather than average price. In this case, it took MSFT a little while to get going after breaking the 200 SMA line. ROC only factors in the beginning and ending prices, while the SMA gives weight to everything in between as well. For this reason, the ROC is less likely to get caught in whipsaw markets.

Short Side Trading

Since I was curious to see how ROC and SMA would compare in a downtrending market, I checked them on the current SLV chart. Based on this single sample, it appears that SMA is a much better downside indicator than ROC. After the price dropped below the SMA line, the ROC line lagged longer than usual. It spent two months bouncing back and forth between positive and negative before finally confirming the SMA line.

Determine trend SLV

While this could be a simple outlier, it appears that ROC is only superior when it comes to uptrends. If this hold true through further testing, perhaps it would be useful to trade using both indicators, having ROC confirm uptrends, and SMA confirm downtrends.

Regardless of what indicator you choose to use, the most important concept is to have an understanding of what a market is doing before placing a trade.

Filed Under: Trading strategy ideas Tagged With: determining trend direction, rate of change, simple moving average

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