Wednesday, January 28, 2015

Overbought Momentum Indicators

Momentum indicators like RSI, Stochastics, CCI and WIlliams %R are setup to identify overbought and oversold conditions. This is the theory.

In reality, the indicators will almost always fail when a strong trend starts.In an uptrend, as we are witnessing, the indicators will soon reach overbought areas. But, this could just be the start of the trend!

These indicators can stay overbought or become choppy in the overbought area while prices keep on going up.  It is happening now!

Experts understand this phenomena, therefore advice that we should not use these indicators during periods of strong trend. 

Ha Ha...

How do you know when a strong trend is starting? I wish I did.

Almost always, once the trend is in full force, then we realize that we are in the middle of what could be a strong trend. Even then, one down day shakes our belief and we start wondering: see the RSI has fallen, prices have come down, maybe this is the start of a down move...

Like most puzzles in trading, there is no clear answer to the use of momentum indicators.This is what I would suggest as a plan:

First, identify the trend. Check the price chart visually, or use a trend indicator. But, develop a view. Trend should be defined as up, down or sideways. Nothing else.

If the trend is UP, then you want to buy the dips. When the indicator becomes oversold, you become a buyer. You ignore any overbought movements.

If the trend is DOWN, then you want to sell the rallies. When the indicator becomes overbought, you become a seller. You ignore any oversold movements.

If the trend is sideways, then you are essentially going for support resistance trades. Here, you buy the oversold and sell the overbought.
 

3 comments:

Manish Chandra said...

I have seen many of the rookie traders trying to trade everything with just one strategy. Unless, we identify Trend vs Sideways and deploy the appropriate tool..we are up for surprise by the market.

Simply put and well done Sudarshan ji !!

Nirav said...

Sir,

Your plan is logical. But then the question comes that when will sideways market starts? It is also very difficult question to answer as a trader.

Vandit Sareen said...

Hi Sudarshan,

Momentum indicators always caught me on the wrong foot - With your simple clear straight forward approach of using them based on the present market trend I find it meaningful include it in some of my trading setups.

Regards,
SAREEN