Overbought Conditions Would Be A Good Thing For Stocks
- Posted by JC Parets
- on June 28th, 2012
Contrary to popular belief, overbought conditions are a positive for stocks. Think about it, if stocks are overbought, then we have unquestionable evidence that buyers are present. But the problem is that what does overbought even mean?
As you guys already know, I am not an oscillator junkie. Far from it. I don’t have 27 indicators underneath price in the charts that I put together. That never made much sense to me. I pride myself in being more of a ‘keep it simple stupid’ type of technician. We look at the Relative Strength Index as a supplement to price, and that’s pretty much it for my arsenal of oscillators.
We always talk about divergences, positive and negative when it comes to RSI. But today, I wanted to look at what ‘mode’ the indicator is in: Bullish or Bearish. The Relative Strength Index compares the magnitude of recent gains to recent losses in a range from 0-100. When RSI is in ‘Bullish Mode’, the oscillator tends get up into overbought conditions (above 70) but never reaches oversold conditions (below 30) and usually bottoms out in the highs 30s or 40. The opposite is also true when RSI is in ‘Bearish Mode’, it tends to reach oversold conditions down under 30 and peaks in the low 60s never getting into overbought levels.
These readings help us determine whether we should have a bullish or bearish bias when looking at price, or perhaps maintaining a bit more neutral position. And right now, after reaching oversold conditions in May, the major averages are working those off trying to get back into the bullish mode that we saw coming into the beginning of the year.
So yes, I think overbought readings in these averages would certainly be a positive. Here’s a look at where we are today. Notice the resistance in RSI right at 60 in the S&P500, Nasdaq100, and Dow Jones Industrial Average:
I think penetration of these bearish mode resistance levels would be a positive for stocks. After reaching overbought conditions in RSI, I would then look for pullbacks to find support around 40, confirming the new bullish mode in the major averages.
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J.C. Parets is the Founder & President of Eagle Bay Capital, LLC. He earned the Chartered Market Technician designation (CMT) and is a member of the Market Technicians Association. More
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