Make Money Trading Overbought and Oversold Conditions

Arul Pandi

Make Money Trading Overbought and Oversold Conditions

Dedicated to passionate traders

to learn & practice trading with

Overbought and Oversold Conditions

Chapter 1

Moving Averages

Moving Average (MA) is a technical analysis tool that constantly averages a security’s prices over a period of time and thereby smooths out price data. This smoothing effect of the moving average gives a clear indication of the direction of the price of the security – up or down or sideways- over a specific period of time. If the moving average curve is rising, it means price is rising; if the moving average curve is falling, it means price is falling. If the curve is directionless and moving sideways, it indicates that the market is in a range.

Moving Average Length

Commonly used moving average lengths (also called “look back periods” and “timeframes”) are 10, 20, 50, 100 and 200.

When an asset begins an uptrend, short term moving averages will start rising much earlier than the long term moving averages. That is, an MA with a short timeframe will react much quicker to price changes than a long term MA.

In the above chart, there are three moving average lines- the 10-day moving average line, the 20-day moving average and the 50-day moving average. It can be observed that (i) the 10-day moving average is the closest line to the price curve, (ii) it tracks the actual price more closely than the longer period moving averages, (iii) it has the maximum number of peaks and troughs, (iv) it generates many more “reversal” signals than a 30-day moving average and (v) the 30-day moving average is the farthest away from the price curve and the smoothest of the three lines.

From the above, one can infer that short period MA like 10-day MA will be suitable for day trading and longer-term MA is suitable for long-term traders.

Types of Moving Averages

There are different types of moving averages. The most commonly used types of moving averages are Simple Moving Averages and Exponential Moving Averages.

Simple Moving Average

A 10-day Simple Moving Average (SMA) adds up the 10 most recent daily closing prices and divides it by 10 to create a new value of average each day.

Exponential Moving Average (EMA)

Exponential Moving Average (EMA), also called exponentially weighted moving average, is a type of moving average (MA) that assigns more weightage to recent data points. That is, each term in the EMA’s period has an exponentially greater weightage than its previous term. There are also a few variants of EMA which use variables like open, high, low or median price instead of using the closing price.

Simple Moving Average vs Exponential Moving Average

If you plot a 50-day SMA and a 50-day EMA on the same chart, you’ll notice that the EMA reacts to price changes faster than the SMA does as more weightage is given to more recent price data in calculating EMA and hence the EMA is more dependable. As EMA depicts the recent performance of the security more clearly and accurately, it makes a better moving average trading strategy.

The following chart shows how SMA and EMA of the same look-back period respond to price.

Interpretation of position and movement  of Moving Averages:

• If the price is consistently above or below a moving average line, you can rest assured that the price trend is strong and the trade can be allowed to run as it is.
• Direction of MA line reflects the market trend. Generally, if the MA on a daily chart is on strong uptrend, day traders will think of going long only. If the MA line on the daily chart is on downtrend, traders will consider going short only.
• The farther the price can pull away from a moving average, the stronger the current trend is. That is, when price curve is at higher level than the Moving Average curve and the price curve is rising, the price trend is said to be bullish.
• When the price line crosses the moving average line, it signals a potential trend reversal depending upon the direction of the MA.
• The longer the price stays on one side of the moving average without touching the moving average, the stronger the trend.
• The slope of a moving average is important. When the price is above the MA and the MA is angled up, it signals a strong trend with prices rising faster than the historical averages. If the MA is angled down, the price is moving down. If the MA is moving sideways, the price is likely to be fluctuating in a range.
• A moving average acts as a good support in downtrend and a good resistance in uptrend. Of course, the price may not respect the moving average always in this way, and it may cross the moving average considerably if the trend is so strong.
• Another important thing to note in MA chart is the rate of change happening between bars. If the price line in a strong uptrend starts losing momentum and starts falling, the MA’s rate of change from bar to bar will be declining, and this declining rate of change of the MA itself is a good indicator of reversal of trend.

Trading Strategies—Crossovers

Crossovers of moving averages of different timeframes provide traders with good trade opportunities as narrated below.

1) Price and MA crossover

When the price crosses a moving average, it is a signal of trend reversal.

• Buy when the price curve cuts the short term moving average curve from below.
• Sell when the price curve cuts the long-term moving average curve from above.

2) Short period and long period MAs crossover

Crossovers of short MAs and long MAs provide profitable trading strategies. The following are a few combinations of different types of moving averages with different look-back periods:

a) Short period SMA and long period SMA crossover

When the shorter-term MA crosses the longer-term MA from below, it indicates that the trend is upward, and it is a buy signal. Crossover of SMA (50) and SMA (200) is highly valued by traders. When the SMA (50) crosses the SMA (200) from below, it is called a ‘Golden Cross’, and when the SMA (50) crosses the SMA (200) from above, it is called a ‘death cross’. b) Short period EMA and long period EMA crossover Similarly, when the short period EMA crosses the longer period EMA from above, it is a bearish signal. Most of the day traders use 12-day and 26-day EMAs which are also used to create MACD. c) Short-period EMA and longer period SMA crossover Another good moving average crossover is short period EMA vs. long period SMA. When short period EMA crosses long period SMA from below, it is a buy signal, and when the short period EMA crosses long period SMA from above, it is a sell signal.

3) Triple Moving Averages Crossover Strategy

Entering a trade too early may involve the risk of trading on false signal leading to losing trade, whereas entering a trade after much caution and time lag may make us miss a sizable portion of profit. Triple Moving Averages Crossover Strategy addresses this issue by giving mostly right trade signals at the right time.

This strategy deploys three moving average lines of different timeframes- small-period, medium-period and long-period moving average lines. Buy signal is generated early as soon as a new trend emerges when the small-period MA line crosses the medium-period from below provided the price is above the long-term MA. Sell signal is generated when the opposite events occur, that is, the short-term MA line crosses the medium-term MA from above and the price is below the longperiod MA.

Our main concern is whether the price line is above or below the long-term MA. Never go long when the price is below the long-term MA line. Similarly, never go short when the price is above the long-term MA.

The combination of 5-, 8-, and 13-days simple moving averages (SMAs) also proves to be a good day trading crossover strategy as this is a Fibonacci-tuned setting.

4) Strategy of taking positions in a staggered manner

In this strategy, the trader will go long for a certain amount when the short-period MA crosses medium-period MA from below and will be taking long positions for a certain more amount when the short-period MA crosses the long-period MA from below, and again will be taking some long positions when the medium-period MA also crosses the long-period MA from below. The trader will exit his positions if any trend reversal is noticed.

5) Moving Average Ribbon

Those traders who do not want to follow numerous charts with different logic, settings and parameters prefer this strategy. They place a large number of SMAs, say, 6 SMAs on the chart. Each SMA’s timeframe will be a multiple of one another so that the chart will give a comparable picture of the market trend.

As you may agree, all the SMA lines will travel in the same direction if the trend is strong.

Now traders are to determine how many crossovers among the MAs will be buy-sell signals. They buy when short-term MAs cross long-term MAs from below. Likewise, they go short when short-term MAs cross long-term MAs from above. Limitations of trading with Moving Averages

• When the price is highly volatile, too many trade signals will be generated. When that is the case, it is better to avoid trading at all.
• Similarly, if two or more MAs are moving almost parallel to each other touching now and then causing weak crossovers without indication of a clear trend, trading on the signals may be avoided.
• As moving averages are formed by historical data, they are lagging indicators i.e., their movements lag behind the movements of price and volume in charts and they do not predict price trend. (Lag is the time taken by a moving average to signal an impending trend reversal.)