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Indicators based on the "advances" and "declines" concept - Overbought / Oversold There are several applications derived from the advances and declines concept that make excellent technical indicators. One that is frequently mentioned is the principle of a stock market being "overbought" or "oversold" (in the following, we will refer to this pair of terms collectively as "overbought/oversold"). Applying "overbought/oversold" as a technical market indicator supposedly gives indications as to what stage the market is at and whether one should buy or sell. However, we find that the terms "overbought/oversold" are being used very loosely in the press and among investors. If pressed for an answer, few are able to define them clearly. So what exactly do the terms "overbought/oversold" mean and how can they be applied to trading in an objective way? The term "overbought" is generally applied to describe a situation where stocks have risen too much (too fast) and/or have become too expensive. But where exactly is the point at which one could objectively say a stock has risen too far (too fast) and how exactly would one make the (objective rather than subjective) determination that a stock has become too expensive? As we noted above, in the absence of a clear, concise, and above all objective definition, the terms "overbought/oversold", as they are commonly (and loosely) used, tells us nothing in particular about the true nature of what is happening in the markets – they only add to the confusion. One a more technical level, "overbought/oversold" are often defined as the points at which prices have moved too far and/or too quickly in either direction (up or down). Usually, the concept of "too far and/or too fast" is applied to one or several moving averages, or in the case of the advances and declines concept, to the difference between the number of advancing and declining issues over a given period. If the market is considered overbought, technical analysts will sell, and if it is thought to be oversold, they will buy. While this may be useful in some cases, it does not explain why we should be buying a market that is oversold or selling a market that is overbought. Moreover, what is the true reason the market is likely to reverse once it has become overbought or oversold? Technical analysts may add something to the extent of, "The market is considered overbought/oversold when a particular indicator has reached a certain level". In our opinion, this does in fact not explain nor define "overbought/oversold"; rather, it simply describes where the "critical point" for a particular indicator lies. The issue becomes even more perplexing when one considers that there are well over a hundred different technical indicators in use today. So, how then do we define the terms "overbought/oversold"? First, it may be stating the obvious (but it is often forgotten) that in order for there to be a trade, there must always be a seller and a buyer - you simply cannot sell shares to "no one". Someone - another trader, a market marker or specialist, broker, bank, mutual fund, etc. - has to buy the shares you are offering for sale. So, logically one cannot say that when a market is "oversold" that "too many shares" were sold.. Let us take a look at example in which we present a highly simplified model of the market. Our particular model involves only two traders who are making buying and selling decisions. Imagine that our two traders (whom we shall call "trader #1" and "trader # 2") each have $50 in cash plus each already own 10 shares at a current market price of $10 per share. Between the two traders, the following transactions take place over the course of several days: Transactions on day 1 On the first day, let us assume that trader #1 wants to buy and trader #2 wants to sell; however, the buy and sell orders are not evenly matched, because trader #1 desires to purchase twice as many shares as trader #2 is willing to sell. We have situation here where the demand exceeds the available supply: trader #1 wants to buy 2 shares and trader #2 wants to sell only one share (at a given price). To satisfy the balance of supply and demand, the price of the shares has to move up (assuming the buyer is willing to pay more (i.e., bid up)). Thus, at the end of the first trading day, the price reaches $11 per share. Here is the tally at the end of the first trading day:
Transactions on day 2 On day two of our hypothetical market model, trader #1 wants to buy another two shares, but trader # 2 is willing to sell only one share and only when the price hits $12 per share. Here is the tally at the end of the second trading day:
Transactions on day 3 On the third day, trader #1 wishes to purchase another two shares. As the price moves up to $13 per share, trader #2 decides that 30% is a good profit and that he would be willing to sell further shares at that price. Trader #1, however, can only afford to buy two shares, because he has now run out of disposable cash. Here is the tally at the end of the third trading day:
At this point, we have situation where trader #1 would be willing to purchase further shares, has however run out of disposable cash to fund further acquisitions. Trader #2, on the other hand, would be willing to sell more of his shares, but cannot find a buyer (at least not at the price he envisions selling at). At this juncture, we could say that trader #1 "has overbought". He kept buying shares as they moved up in value and this has depleted his cash. Trader #1, should he wish to participate in further trading activity, will have no choice but to sell a few shares in order to fund possible future purchases. Trader # 1 will now become a seller - there will now be two sellers where before there was only one. Because both traders are now in sell mode, this will drive the price down, at least to the point where trader #2 is ready to become a buyer (he has cash). Below you see a graphical representation of what happened in our market model:
The above is, of course, a very simplistic model of how a market operates. The market is infinitively more complex: we have a great many participants (ranging from individual traders to various companies, funds, banks, even governments); there is borrowing on margin; there is short selling; there are options and futures; there is money flowing in and money flowing out (withdrawals, liquidations, redemptions); traders are constantly changing their minds (today they want to sell, tomorrow they want to buy); new companies are starting to trade on the exchanges (shares dilution); companies may go bankrupt, and so on.. Regardless of the market’s great complexity, the following principles outlined in our market model hold true:
In summary, after a long run in one direction, the appearance of a big volume surge means that a large number of shares are being transferred from one group of market participants to another; it is at this point that the market can become "overbought" or "oversold". By analyzing this volume surge (how big is it, how far away is it from a previous reversal point, how prolonged in time is it), you can anticipate when the market is likely to reverse in the short-, mid-, or long-term. The advances and declines volume can assist you in making that determination because it shows exactly where the major trading activity is concentrated (in what group: advancing issues of declining issues). The conventional definitions of "overbought/oversold" are not wrong, they simply do not tell the complete story or provide the entire picture. On the other hand, we think most investors do not necessarily want a detailed analysis anyway. Just imagine if the newscaster provided the following version of a market that is "overbought" and has started to reverse: "The number of investors who are able and willing to pay up for their shares has now been overcome by the number of investors who are willing to sell their shares, even if at lower prices. This is shifting the demand/supply balance to the sell side and is pushing the markets down". Nobody would listen to this, the majority wants simple statements such as, "Investors are currently selling out in droves" or "investors are taking profits ". These "explanations" do not require a lot of thinking or analysis. The newscaster delivers the news in a way acceptable to the majority - and there is nothing wrong with that. Our more elaborate explanation is simply designed for those who wish to learn more, and come to a better understanding of why and when things are happening in the markets. A. v. S. Copyright 2004 - 2008 Highlight Investments Group. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.
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