The Australian market has been climbing strongly higher during the last two weeks, but is it overbought at the current levels?
The term overbought simply means it has climbed too high, too fast, and in this situation there is the possibility of the market pulling back. We can use some of the indicators found in The Bourse to answer this question.
The indicators that are used to show overbought or oversold conditions are known as oscillators. These fluctuate backwards and forwards between two extremes, often 0 and 100, or -100 and +100. When the indicator is at the lower level it shows an oversold condition and when it is at the top it shows an overbought condition.
Oscillators that are widely used include Relative Strength Index (RSI), Stochastic or the Williams %R. In The Bourse, when you click on the IND button at the top of your chart, you can select the indicators you want to use from the menu. Click on the Oscillators heading to display the indicators available.
The list includes RSI, Williams %R, Price Oscillator, Momentum, Stochastic and MACD. I personally use the MACD to identify trends, and not as an indicator to identify overbought or oversold conditions.
The Relative Strength Index (RSI)
The RSI shows the relationship between up movements and down movements in the share price. The more up days that occur, the higher the RSI value. Typically the indicator is calculated over 14 days. When the RSI hits an extreme, which is measured as below 30 (oversold), or above 70 (overbought), then look for a reversal in the current trend. By applying the RSI on to the chart of the Australian market (XJO) we can clearly see an overbought condition with an RSI of 84. This is well above 70, which is considered overbought.
The Stochastic (Cstats) Indicator
The stochastic is a fast moving oscillator that identifies whether the share is closing closer to its highs or lows. Time frames used can vary, but here we use 14 days and the slow stochastic is normally smoothed by a period of 3 days. The extremes in the stochastic are typically identified as 20 (oversold) and 80 (overbought) from which a reversal is expected.
Adding this to the chart shows the stochastic is also in overbought territory with a reading of 96. Clearly the market is overbought at current levels, but this does not mean we are about to enter a new bear market. It simply means the risk reward favours a trade in the downward direction or locking in some profits. A similar setup in mid December led to a small decline in early January, while the peak that occurred in early November resulted in a more substantial decline through November.
You can use oscillators in The Bourse to identify overbought conditions. These can be a useful guide to assist you to know when to take profits or even to sell short. The same indicators can be applied to individual shares as well as the market as a whole.
By Jeff Cartridge
Education Manager
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