Thursday, August 11, 2011

How to play an oversold relief rally

Wow! The Fed relief rally that began Tuesday evaporated on Wednesday like the morning dew.
I have learned from bitter experience that over-reliance on overbought/oversold models can be a route to the poorhouse. So here is a better way to use OBOS models to play an oversold bounce. Consider, for example, my favorite overbought/oversold model* (but this is applicable to any OBOS model such as the popular RSI indicator):

Oversold markets can get more oversold and overbought markets can get more overbought. In fact, my former Merrill Lynch colleague used the term "a good overbought" condition to describe an uptrending market or stock that rallied, paused and rallied again.

I have found that a better way to play an oversold bounce consist of the following:
  1. Wait for the oversold condition;
  2. Buy when the market exits the oversold condition.
While this method isn't perfect, it avoids much of the draw-downs that come from buying a panicky falling market or shorting an overexuberant bullish market.

Warning: This technique isn't for the faint of heart. But if you can stand the risk and want to play a rally here, then wait for the oversold condition to clear itself before entering the market on the long side. As I write this, ES futures are up about 1% so we have a shot that Thursday will be an up day, which would could prove to be the start of a relief rally that typically lasts 1-3 weeks.

* For traders who want to monitor the readings of this model on a daily basis, click on this link.


Andy Dong said...

How do you define a oversold condition relatively easily without guessing it?

How to determine the whether has exit the oversold condition?

Andy Dong said...

Is there a easily define metric for oversold condition? e.g. 5 straight day of more than 1.0% down movement.

How to determine when the market exits the oversold condition?

Cam Hui, CFA said...

Sorry there is no standard definition. You need to look at some of the standard OBOS tools, such as RSI.