Monday, June 23, 2008

Oversold. Is this a valid technical indicator ?

In just four trading days, the Nifty has fallen from a high of 4680 to a low of 4226 (today, Monday). That's a 454 point decline, or 10% from the high to low. The current down move started on May 2, when the Nifty peaked out at 5300. Since then, the Nifty has seen four down swings (including the current down trend) with small up moves or trading ranges in between. The current 10% down swing is the sharpest decline of the four down swings. Going by these simple numbers, it is possible to suggest that the Nifty may be ready for a sideways consolidation or even some kind of relief rally.
When there is a high probability of a reversal, Swing Traders should take profits on existing positions by closing the position or taking partial profits. This step is neccessary to protect their equity. But, taking of profits is not a signal to take a reverse position. Our charts have not signalled a reversal. The charts suggest that the risk of reversal has increased so profits should be protected. For short term traders, the protection of existing open position profits is sensible strategy.
Now to our original question: Oversold. Is this a valid technical indicator ? defines oversold as a technical opinion that the market price has declined too steeply and too fast in relation to underlying fundamental factors.
Now the problems start. Who determines the underlying fundamental factors ? This is quite subjective, isn't it ? It is possible that prices are catching up with poor fundamentals. Worse, maybe, fundamentals and prices are going down the drain, together. Therefore, the concept of 'oversold' is flawed when it is evaluated in relation to underlying fundamentals.
In the classic example of a stock getting oversold, buying is justified since the stock price has diverged from its fundamentals. In real trading, there is always a good reason why stock prices have diverged. We want to listen to the voice of the market which is reflected by price action. Fundamentals are usually a view of the fundamental analysis community. This view is often flawed since it carries a large amount of self interest with it.
Oversold then as we understand it is not a valid technical indicator.
But protection of positions when risk of reversal is high is a valid trading startegy. The reversal may never happen, and certainly there are no signs of reversal when we begin our profit protection program. For Swing Traders, oversold is not a signal to go long. It is a signal to protect profits from short positions.