Recently the Aussie market hit new highs above 4800 and has since pulled back. Was this pullback expected? Well, for some traders it was. The main reason for expecting a pullback was the fact the market was overbought at this time.
So what is overbought (or oversold for that matter) and how do we identify it?
The term overbought is often used by traders when referring to individual shares or markets too far away from what the trader considers to be normal or fair value. Even though few traders will agree on the fair value of a share, there are ways to measure what could be considered fair value from a fundamental and a technical standpoint.
Imagine that a share is attached to its fair value by a rubber band. As the share moves further away from its fair value the rubber band stretches, and the further away from fair value the more the rubber band is stretched. The more stretched the rubber band gets the more likely it is to snap back and pull the price back towards the fair value. So let’s look at a couple of ways to look at fair value, then overbought signals. For these examples we’ll be using The Bourse charting software.
A moving average is an average of the price over a period of time. The longer the time period is the smoother the average will be. In The Bourse you can choose from a simple moving average, an exponential moving average or a weighted moving average. The choice of average is not important, with the exponential and weighted moving averages providing more weight to the recent data. The time periods you use will depend on how often you are trading. As a guide I prefer to use a timeframe of around 20 days (approximately one month’s trading).
In the chart below you can clearly see that BHP moves above and below its average, or “fair value”, stretching out and then contracting the imaginary rubber band. We now have a visible reference for overbought or oversold in relation to the moving average. In a similar way you can use a trend line as a measure of fair value and visibly see the deviation from the line to determine whether the share is overbought or oversold.
Now we have determined fair value using a moving average, we can actually put boundaries around the moving average to show overbought or oversold conditions, rather than just measuring it visually. The Bollinger Bands are arranged around a moving average and are 2 standard deviations away from the average. The outer bands include 95% of the price movement. If the price is near, or outside the top band, then the share is overbought, if it is near or below the bottom band it is oversold. A reversal is likely to be close at hand when either of these conditions occur. Looking at the chart below we can see CSL Limited has bounced back and forward between the two outer bands for months.
There is another way to measure oversold objectively, and that is by using oscillators such as RSI, Stochastic or Williams %R. An oscillator “normalises” price action and plots it on a fixed scale, often between 0 and 100. Reference lines are then drawn on the oscillator to mark extreme movements which could be considered overbought or oversold. The level of these references do vary, but The Bourse will plot the default reference levels for you.
When you look at the chart of ANZ Bank below, the overbought areas are marked by the vertical line which is drawn where the RSI indicator touches or breaks above the 70 level. When this level is reached, start looking for a reversal.
If you review these three charts, and others as well in The Bourse, you will see how the market was clearly overbought recently and that a pullback in the market was imminent. As of today the chart of CSL is still overbought, so keep an eye on CSL for signs of a reversal.
By Jeff Cartridge