Technical Trading Basics: Using Overbought And Oversold Signals To Buy And Sell


Summary

  • The biggest money is made understanding where market pivots are and acting on that information.
  • The power of narrative can create uncertainty and emotional reactions for investors, controlling those impulses is vitally important.
  • Technical indicators can help serve as signposts for when to buy and sell, with a clear bias towards buying for the long-term.
  • Using Relative Strength Index, Money Flow Index, Chaikin Money Flow and MACD, we identify most overbought and oversold conditions in assets to reduce risk and find opportunities.
  • Worked on this for a week. I really hope you find it very useful.

“I believe the very best money is made at the market turns. Everyone says you get killed trying to pick tops and bottoms and you make all your money by playing the trend in the middle. Well for twelve years I have been missing the meat in the middle but I have made a lot of money at tops and bottoms.”

Paul Tudor Jones

Paul Tudor Jones is one of the best stock market traders and investors of all-time. We are not Jones, so we have to be careful to manage risk smartly. “Buy low and sell high” is the general gist of his quote. We should always remember to take heed of it.

Our goal as investors is to manage risk FIRST. 

Technical analysis is the final leg in our investment process.

  1. Secular Trends
  2. Government & Central Bank Policy
  3. Industry & Company Fundamentals
  4. Technical Analysis Of Price Trends

Technical analysis guides us when to buy and sell. Every successful money manager uses it to some extent. 

LESS RISK IS WHAT MAKES MORE MONEY

Technical analysis helps us manage risk. 

Prices regularly rise or fall for reasons that we do not understand or agree with. Sometimes the market is trying to tell us something. Sometimes it is just speculative narrative noise from fear and greed – this is often the case in the short term. 

We should be humble enough to consider that sometimes “the market” is telling us that there is information that we don’t know. This is important for parsing out true long-term fundamentals. Think of technical analysis as giving us signals to do more research or our positions.

Pivots On Overbought And Oversold

Technical analysis helps us find the pivots that Jones talks about. Using some simple technical signals, we can often get very good ballpark estimates of the overbought and oversold conditions that precede turns in an assets price. Respecting these signals can save you a lot of money and make you a lot more. 

Overbought simply means that too many people have bought an asset for new buyers to have any meaningful impact on pushing the price higher. This usually results in profit taking and a price decline (if fear and momentum set in, prices can drop substantially, 50% is not uncommon). 

Oversold means that most people interested in potentially selling have done so. Presuming the asset has value, this usually indicates a turn back up in price as new buyers emerge (the better the asset, the faster new buyers emerge).

Always keep in the back of your head that 75% of the time, we are looking for ways to “get long” the stock market. That is, add equity positions. We do this because we know on average 3 out of 4 years have positive stock market returns. This aligns with the typical 4-5 year business cycle and recessions that occur on average every 5-10 years.

Our bias is always intermediate and long-term positive, that is bullish. It is only every few years that we will be short-term negative or bearish. 

Once we have entered a position on an oversold condition, then, presuming it begins to rise eventually, we will generally want to ride the winner until it at least is approaching an overbought condition.

In general, we will ride the middle of the market if we have entered early enough. We do not want to enter a position while a stock is in the middle of the market unless there is a broader long-term trend at play. Reversals prior to full overbought or oversold conditions happen all the time, thus making the middle of the market higher risk than buying near the pivot points just before or after the pivot has occurred. It is alright to wait for the pivot to occur and get in a day or week late as that approach can help you manage your risk. 

Trading Against The Masses

We are primarily “position traders.” That is, we are looking for investments that can carry us through an entire sub-cycle of a bull market or an entire cyclical bull market. Trades generally last 6 months to several years.

Think of a full cycle in a market as a giant wave. The subcycles are waves within the bigger wave. Elliott wave is a way to estimate crowd psychology.

Sometimes the crowd moves mostly to one side of the ship to look for their whale investment, sometimes they run back to the other side. The repetitious psychology of crowds is what drives trading patterns.

For our RARE swing traders, using the shorter term time frames can add significant impact to portfolio performance. Just a few trades per quarter can double returns when managed for risk first.

Technical analysis can help you manage risk by avoiding bad entries and selling a small loser before it becomes a big loser. Technical analysis will also give you the information you need to ride your winners longer for bigger gains.

In the internet driven world of information, the power of narratives have become extremely powerful. Do not underestimate how extremely powerful certain narratives can become for periods of time.

Narratives that feed on fear and greed are the most powerful for investors. People do not like change. They do not like other people who are not like them. People love to believe they are smarter than everybody else, it’s a form of self-validation. Narratives play into those human traits.

I contend that “self-validation” via rationalization, is the third most prevalent characteristic among humans after self-preservation, that is staying alive, and procreation. Constant battles with self-validation, especially driven by narrative dogma, can lead to horrible life patterns. Be objective, be introspective, be happy. 

Think of the common narratives that pound us everyday. Some are true, some are false, most are in between. These narratives make us laugh, cry and become a part of us. We find these narratives in the media, books, movies, fairy tales, religion and all over the internet. 

It is only normal that we grasp onto narratives when investing. Accepting narratives is programmed into us. We love stories. We are conditioned. That’s why technical market indicators that measure sentiment, which is a reflection of narrative, is vitally important to your investing. It is a way to control your own emotions.

I suggest that every investor should read this book by Dr. Robert Shiller: 

Narrative Economics by Robert J. Shiller

Here are four simple to learn technical tools to use for trading against the masses and reduce your reliance on narrative. 

Relative Strength Index

Relative Strength Index – RSI

Per TradingView:

“The Relative Strength Index [RSI] is a well versed momentum based oscillator which is used to measure the speed (velocity) as well as the change (magnitude) of directional price movements. Essentially the RSI, when graphed, provides a visual mean to monitor both the current, as well as historical, strength and weakness of a particular market.

The strength or weakness is based on closing prices over the duration of a specified trading period creating a reliable metric of price and momentum changes. Given the popularity of cash settled instruments (stock indexes) and leveraged financial products (the entire field of derivatives); RSI has proven to be a viable indicator of price movements.”

Relative Strength Index is measured between zero and 100. RSI is considered overbought when above 70 and oversold when below 30. Signals can also be generated by looking for divergences, failure swings and centerline crossovers. RSI can also be used to identify the general trend.

The concept of a divergence is important for us to understand. This is when the price of an asset continues to rise even as RSI begins to fall. This is an early warning sign of an impending fall in price. 

When the daily measure of RSI begins to fall, a stock’s or ETF’s price will start to fall within about a week, sometimes the next day. You will need to be aware of support levels to understand how much downside risk there is when RSI becomes extreme, that is, over 70, and then stops rising.

The daily measure of RSI is most useful to measure shorter term price moves. Go back to the subwave within the wave idea. 

A weekly measure of RSI gives us a very good idea of the longer-term trend for a stock. When the weekly measure of RSI begins to fall, a stock is generally already in correction.

Daily and weekly measures are exactly as they sound like. The daily chart measures in daily increments. The weekly chart measures in weekly increments.

Often, when the weekly RSI is in the “middle of the market” but rising, the pullbacks to oversold or nearly oversold on the daily RSI is often a good place to enter a stock position that you might have missed earlier.

Money Flow Index

MFI
Money Flow Index – MFI

Per TradingView:

“The Money Flow Index indicator [MFI] is a tool used in technical analysis for measuring buying and selling pressure. This is done through analyzing both price and volume.

Like RSI, the MFI’s calculation generates a value that is then plotted as a line that moves within a range of 0-100, making it an oscillator. When the MFI rises, this indicates an increase in buying pressure. When it falls, this indicates an increase in selling pressure.

The Money Flow Index can generate several signals, most notably: overbought and oversold conditions, divergences, and failure swings. Over 80 is overbought, below 20 is oversold.” 

The main difference between RSI and MFI is that MFI uses volumeMore volume, stronger move. For that reason, I gravitate towards MFI as my main “easy to look at” indicator. 

The same ideas with RSI apply to MFI. When a divergence occurs between MFI and price trend, be very aware. Also, when MFI changes direction at a different time than RSI, consider what the charts are telling you there. Has there been a shift in sentiment. Is the change in volume a tip off? 

Money Flow Index [MFI] vs Relative Strength Index [RSI]

The core difference between MFI and RSI is the volume component. Therefore, stronger and weaker volume can mean different things.

In general, if MFI trails RSI, that is below RSI, that is a sign of underlying weakness in a stock. On the way up, low volume is not fully supporting the move. On the way down, high volume is pulling price down.

Conversely, if MFI leads RSI, that is above RSI, that is a sign of strength. One the way up, high volume is pulling price upwards. On the way down, lower volume is showing that selling is exhausting faster than RSI might indicate.

Think about this as a logic equation. 

Of course, no measures are perfect and the stock market likes to play tricks on people. However, the chart above is a logic based shortcut and usually a very good guidepost to start with.

Comparing RSI and MFI

One last note: 

RSI and MFI both typically use 14 periods to measure. The daily chart is 14 days. The weekly chart is 14 end of weeks.

I have been using 10 to represent two weeks on the daily charts as the markets are moving faster now and I want a little head start on other investors. I also look at weekly over 10 weeks versus 14 now given the speed of markets.

You can certainly experiment with different time frames to give different perspectives. I will often align the start of a period with a major economic, political or social event to see if it gives any insights in change in market sentiment.

Chaikin Money Flow [CMF]

Chaikin Money Flow
Chaikin Money Flow – CMF

Per TradingView:

“Chaikin Money Flow [CMF] is a technical analysis indicator used to measure Money Flow Volume over a set period of time. Money Flow Volume (a concept also created by Marc Chaikin) is a metric used to measure the buying and selling pressure of a security for single period. CMF then sums Money Flow Volume over a user determined look-back period. Any look-back period can be used however the most popular settings would be 20 or 21 days.

Chaikin Money Flow’s Value fluctuates between 1 and -1. CMF can be used as a way to further quantify changes in buying and selling pressure and can help to anticipate future changes and therefore trading opportunities.”

Chaikin Money Flow [CMF] is another way to tell the story of underlying demand for a security.

With both positive and negative measures, it should be pretty apparent that negative numbers are bad as that means there are more sellers than buyers. A stock or ETF cannot rise intermediate or long-term with more selling than buying. Simple supply and demand.

The concepts of divergences comes into play here as well. If money flow starts to fall while price is rising, then the price will generally follow downward soon. Again, a change in money flow is a signal that something is about to change with price.

A falling CMF that gets into negative territory almost always indicates a decline in share price or at a minimum a choppy market. If you are not comfortable with a choppy market, then selling is a more likely thing for you to do.

The importance of measuring different time frames is important with CMF as well. The daily is a measure for short term traders. The weekly and monthly tell you the real big money trend. We want to be on the side of the big money.

If daily CMF shows flows out of a stock, but the weekly and monthly are both trending up, without being extreme, those short-term pullbacks are good times to buy as they typically indicate a small correction and choppiness for a short period. Always be wary however that a change of direction could be occurring in case the a turn comes in the middle of the market, although I will say, that is rare without an event.

I use the standard 20 period CMF. On the daily chart that represents four weeks, or about a month, of trading days. It is a good contrast to the 10 or 14 period measures for RSI and MFI. 

Experiment with different time frames here. Bring CMF down to 10 to see how it compares to RSI and MFI. 

MOVING AVERAGE CONVERGENCE / DIVERGENCE, aka, The Big MACD

MACD
MACD

Per TradingView: 

“MACD is an extremely popular indicator used in technical analysis. MACD can be used to identify aspects of a security’s overall trend. Most notably these aspects are momentum, as well as trend direction and duration.

What makes MACD so informative is that it is actually the combination of two different types of indicators.

First, MACD employs two Moving Averages of varying lengths (which are lagging indicators) to identify trend direction and duration. Then, MACD takes the difference in values between those two Moving Averages (MACD Line) and an EMA of those Moving Averages (Signal Line) and plots that difference between the two lines as a histogram which oscillates above and below a center Zero Line. The histogram is used as a good indication of a security’s momentum.”

Signal line crossovers are what we want to look for. We can look for the instance just before a crossover occurs as well if we want to be aggressive.

From troughs, we want to see the MACD line start to move up and through the signal line to indicate a bullish move in price. At peaks, we have to be wary of the MACD line starts to move down through the signal line which usually means a move down in price.

I use MACD as a confirmation of changes of direction when my overbought/oversold signals are given. MACD is not an overbought/oversold signal itself, rather, it is a timing indicator that I use to either hurry or be patient.

Bonnie Gortler, who worked for the creator of the MACD, Gerald Appel, for three decades and managed money using MACD, has agreed to write an article about effective ways to use MACD. It will be linked here when ready and you will be able to find it via the search on the site.  

Fibonacci Levels And Buy Zones

One of the key things you see on my charts are Fibonacci levels. 

Per TradingView:

“Fibonacci was an Italian mathematician who came up with the Fibonacci numbers. They are extremely popular with technical analysts who trade the financial markets, since they can be applied to any timeframe. The most common kinds of Fibonacci levels are retracement levels and extension levels.

Fibonacci retracement levels indicate levels to which the price could retrace before resuming the trend. It’s a simple division of the vertical distance between a significant low and a significant high (or vice versa) into sections based on the key ratios of 23.6%, 38.2%, 50% and 61.8%.Price tends to come back to these levels before continuing the predominant trend.

Fibonacci extension levels indicate levels that the price could reach after an initial swing and retracement. TradingView has a smart drawing tool for Fibonacci retracements and one for Fibonacci extensions that allow users to visually identify these levels on a chart. Both tools are fully customizable and levels can be changed or added.”

For whatever reasons, Fibonacci numbers are recurring in nature. There are many instances and correlations. Nobody knows exactly why, it just is.  The markets respect these ratios.  

Wikipedia had a good page on Fibonacci numbers if you are curious (I hope you are, good traders and investors are curious):

“Fibonacci numbers are strongly related to the golden ratioBinet’s formula expresses the nth Fibonacci number in terms of n and the golden ratio, and implies that the ratio of two consecutive Fibonacci numbers tends to the golden ratio as n increases.

Fibonacci numbers are named after Italian mathematician Leonardo of Pisa, later known as Fibonacci. In his 1202 book Liber Abaci, Fibonacci introduced the sequence to Western European mathematics,[5] although the sequence had been described earlier in Indian mathematics,[6][7][8] as early as 200 BC in work by Pingala on enumerating possible patterns of Sanskrit poetry formed from syllables of two lengths.

Fibonacci numbers appear unexpectedly often in mathematics, so much so that there is an entire journal dedicated to their study, the Fibonacci Quarterly. Applications of Fibonacci numbers include computer algorithms such as the Fibonacci search technique and the Fibonacci heap data structure, and graphs called Fibonacci cubes used for interconnecting parallel and distributed systems.”

On my charts, I show Fibonacci retracements and extensions. The left hand side are retracements, which are measured at a major pivot from a trough to a peak. On the right side are extensions which are measured at pivots from trough to peak to trough. 

I show two time frames, the long cycle which I believe the market is keying on and the most recent time frame. I will sometimes add a third time frame if I feel I need more information. 

While we can use any line as a support or resistance line, it is best to look for “confluence.” That is, where 2 or more lines are very close together. These areas provide stronger support or resistance. 

The Fib ratios are the basis of the yellow buy zones that I have on the charts. Within those ranges, you can look to buy, if:

  • there is not significant downward momentum. Use the other indicators to help determine that. If there is significant down momentum, hold off on buying until that momentum breaks – which is usually in the middle of a day. It is okay to wait a bit for confirmation as part of your risk management process. Don’t feel in a hurry to buy. There is ALWAYS another opportunity in the stock market.
  • nothing has fundamentally changed with the asset in question. 

Other Technical Indicators

There are many other technical indicators. Many are very valid and could support your type of investing or trading. Experimenting will help with overall understanding. 

You will notice at the bottom of my charts a small section I did not cover. It is a handmade indicator that measures 3 exponential moving averages of 10 periods, 20 periods and 50 periods. These are usually measured in days, but you can certainly use weeks or months as your periods. 

I use this to show me when three important time frames all start to move or roll over in a different direction. What I have learned is that when EMA starts rolling over on every time frame, then it is time to sell. 

I will also loosely use Elliott Waves. In general, the longer the wave pattern, the more it tells you about the big trend. However, Elliott Waves, in my 25 year opinion, are just another way to identify common repeating patterns. It is not good at forecasting change in my opinion.

Events disrupt Elliott Waves repeatedly in my experience. For example, Elliott Waves were not very useful in projecting the Coronavirus Crash ahead of time. However, tracking the money flows told us ahead of time that the stock market correction we expected sometime in 2020 was coming sooner and harder than otherwise. 

Here’s a chart I put out before the first big volatility event in 2018: 

SPY Risk is repeating and a reset is due.

Look what happened since that chart was published around New Year’s 2018: 

Ominous Head & Shoulders Pattern for S&P 500. Will it end in a significant correction? Time will tell…

The 3 dark red humps are a “head and shoulders” pattern that developed over a two-and-a-half year time frame. It is very ominous. Based on this chart and the economics we are seeing in mid-2020, only Federal Reserve or government policy (step 2 in our investment process) is likely to prevent a deep correction. How would an Elliott Wave predict government or Fed policy? Therefore, no Elliott Waves were harmed in the making of this chart. 

Essential Technical Analysis Book

Here is the first of several technical analysis book from our “Investment Trends Book Club” list. It’s a great place to start learning the basics and some of the advanced of technical trading.

JACK D. SCHWAGER is the CEO of Wizard Trading, a commodity trading advisory firm that has been managing client funds since 1990. He is the author of The Complete Guide to the Futures Markets, Market Wizards, The New Market Wizards, Fundamental Analysis, and Technical Analysis.

I strongly suggest reading this. Kindle is great and cheap, but I recommend a paper copy so you can scribble in the margins. 

Getting Started With Technical Analysis

Getting Started With Technical Analysis – Jack Schwager

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it and have no business relationship with any company whose stock is mentioned in this article.