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Posts Tagged ‘RSI’

Are Overbought-Oversold Indicators Reliable Predictors of Short-Term Market Performance – a 100-Week Backtest

Thursday, March 12th, 2015

This week I would like to report on a study I recently made for Terry’s Tips paying subscribers.  I checked out the validity of a popular way of predicting whether the short term market might be headed higher or lower.   I think you will find that the results are astonishing.Terry

Are Overbought-Oversold Indicators Reliable Predictors of Short-Term Market Performance – a 100-Week Backtest

One of the most popular indicators in many analysts’ toolbox is the overbought-oversold numbers generated by the current RSI.

I have never figured out how to get reliable information from reading charts, although many people apparently find them useful.  The same goes for the overbought-oversold indicators.  On the other hand, I know that many people believe in these numbers, and every Saturday for over ten years, I have published these indicators for SPY, DIA, IWM, and QQQ for subscribers to my options newsletter, Terry’s Tips.

Each week, we average the 2-day, 3-day, and 5-day RSI numbers for these popular ETFs and used the following ranges to determine where the ETF stood at the close on Friday:

Very overbought – an RSI reading of greater than or equal to 85.0
Overbought – greater than or equal to 75.0
Neutral – between 30.0 and 75.0
Oversold – less than or equal to 30.0
Very oversold – less than or equal to 20.0
Extremely oversold – less than or equal to 10.0

Last Friday, March 6, both SPY and DIA were “Very Oversold” and IWM and QQQ were “Oversold.”  This prompted me to wonder what that might mean for the market this week.  Were these numbers significant indicators or not, I wondered?

I went back and checked the results for the last 100 weeks from my Saturday Reports.  Here are the numbers for SPY, perhaps the best measure of “the market:”

Neutral – 47 weeks
Overbought – 16 weeks
Very Overbought – 22 weeks
Oversold – 5 weeks
Very Oversold – 8 weeks
Extremely Oversold – 2 weeks

A little less than half the time (47%), the reading was neutral.  In 38% of the weeks, SPY was overbought or very overbought, and in 15% of the weeks, it was in some sort of oversold condition.

I then checked out how SPY performed for the subsequent seven days. Here are the numbers showing what happened to SPY in the week following the condition reported in each Saturday Report:

overbought oversold chart march 2015

overbought oversold chart march 2015

When SPY is overbought, the technicians would expect that the market would be weaker in the next week, but just the opposite was true.  In fact, in 81% of the weeks when it was overbought, SPY rose in the subsequent week.  It also went up in 64% of the weeks when it was very overbought.

Clearly, being overbought or very overbought is an absolutely worthless indicator of a lower market.  In fact, in subsequent weeks, for the most part, the market outperformed.  If the market rose by the average percentage when it started out either overbought or very overbought every week of the year, it would go up by over 61% for the year.  In other words, being overbought or very overbought is an excellent chance to bet on a higher market for the next week (rather than the opposite).

The oversold condition is an entirely different story (based on the last 100 weeks).  Being oversold or extremely oversold is essentially a meaningless indicator – the market rose or fell in just about the same number of weeks following one of those conditions.  However, being very oversold seems to be an excellent indicator of a higher market.  In 83% of the weeks when it was very oversold, it rose in the subsequent week.  The average market gain in those weeks was 1.21% (62% annualized).

Another interesting result is that anytime SPY is anything except neutral, it is a decent indication that the market will move higher in the next week.  Being very oversold is the best positive indicator, but being overbought is almost as good a positive indicator (even though this is absolutely contrary to what many technicians would expect).

Last Friday, SPY was very oversold.  That occurs in only 8% of the weeks, and for the past 100 weeks, the market was higher 83% of the time in the subsequent week.  As I write this before the market opened on Thursday, so far, SPY has dropped by exactly $3 (1.45%).  This time around, it looks like even the historically most reliable indicator is not working as expected, either.

Bottom line, if you are trying to get a handle on the likely one-week performance of the market based on the overbought-oversold condition on Friday, you are bound to be disappointed. These indicators just don’t work, except possibly the very oversold indicator (and this week is a reminder that even this one is not always right, either).  Maybe the results would be different if you checked on the one-day or two-day changes rather than the one-week variations, but that is something for someone else to check out.

An Interesting Post-Expiration Play

Monday, July 30th, 2012

Last week we made a little trade that doubled our investment in one day.  Every month, a similar opportunity presents itself.  Of course, it doesn’t always work out this nicely, but it seems to do well most of the time.  Today, I would like to share our thinking with this trade.

An Interesting Post-Expiration Play

Many investors are aware of a couple of phenomena which seem to prevail in the market.  The first is that the Monday after the regular monthly options expiration is generally a weak day for the market.  The second is that the first trading day of each month is usually a strong day.

When other indicators also suggest that these generalizations might hold true, it might be a good time to make the outright purchase of a put or call.

On Friday, July 20, the regular monthly options expired.  At that time, the market was also in an overbought condition (one of the indicators that we follow, RSI, was over 70).  Overbought conditions are not nearly as important indicators as are oversold conditions, but they are something to consider nonetheless.

Our favorite ETF to use when buying options is the Russell 2000 Small-Cap (IWM).  It seems to fluctuate in the same direction as SPY, but by larger percentages.  On expiration Friday, with IWM trading right around $79, we bought a Jul4-12 Weekly 79 put for $.85.  Actually, we bought 5 of them, shelling out $425 plus $6.25 for commissions (our broker, thinkorswim, charges Terry’s Tips subscribers a flat $1.25 per option contract).

On Monday, we placed a limit order to sell those puts if the price got up to $1.73.  The stock tumbled almost $2 on that day, and our order executed.  We were delighted to double our money after paying the commissions.  After commissions, we made a profit of $427.50 on our initial investment of $425.

We could have made more if we had waited a little longer, but we’ll take double our money any day.  Selling when we did ultimately proved to be a good idea because by the end of the week, our puts expired worthless when the stock rose to above $79.

Last week was a great one for anyone who bought either puts or calls.  Option prices were low (lower than they are this week) and volatility was high.  If you were willing to accept a moderate profit on your option buy, you could have done well either with puts or calls last week.

For most of the past couple of months (and all of last summer as well), option prices have been lower than the actual volatility of the market (SPY, and IWM).  This means that a good strategy has been to buy options rather than sell them (which is our usual preference).

This week, the first trading day of August falls on Wednesday.  We might be inclined to buy a call on IWM because the market is often strong on that day.  However, option prices (VIX) rose 5% Monday morning so options are not quite so cheap this week.  With the big run-up in the market last Friday (SPY gained almost 2%), we are probably due for some weakness soon, so we are probably not going to buy a call this time around.  We like to see other indicators which support our buying decision, and we don’t see any at this point in time.  (RSI is neutral, for example.)

Buying options is still probably a good short-term idea, but sometimes it is safer just to sit on the sidelines for a week or so and wait for a more opportune time.

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