Profiting from an Oversold Market

Oversold Market

In recent days, we have seen markets butchered by selloffs bleeding red all over the screens. The sense of a looming Armageddon echoes in the news with danger lurking in the shadows. And when the experienced trader sees all that red he begins to twitch with that natural trade reflex. That is the reflex that he or she must trade on the rebound. After all, oversold markets create big rebounds, right? Certainly, they can. And this is why, today, our focus is on how to trade a rebound after an aggressive selloff.

Signs of an Oversold Market

I’ve heard it said, and I fully agree, that the market can be likened to a rubber band. It stretches and stretches until it reaches its maximal elasticity. Then, given its natural tendency, it shrinks back. In this particular case, we’ve got an oversold market, i.e. it’s stretched like a rubber band. But how do we know that it’s nearly reached its maximal elasticity, and that it’s ready to shrink back?

There are, of course, many methods to identify this maximal stretch. Everyone is entitled to a personal favorite; mine is a combination of two indicators which I believe work best for short term rebounds. It is the combination of an indicator known as the Rate of Change (ROC) and the ever popular Bollinger bands as an overlay.

Combining Rate of Change and Bollinger

Source: e-signal

Low vs Closing Price

I can’t stress enough how timing is of the essence when it comes to trading an oversold market. Therefore, some validations are needed to ensure your timing is, indeed, correct and that the selling momentum is over. From personal experience, my validation or cue is a candle with a long needle, which signifies a large gap between the session low and the closing price. What that all means, essentially, is that the market is running out of sellers. When it comes in tandem with our ROC signal, it’s a sign of an oversold market ready to rebound. That, of course, is our entry signal.

A Few Good Rules of Thumb

Before you begin to test this strategy on an oversold market, let me leave you with a few ground rules. From personal observations, the best time frame to use the ROC is daily. An hourly time frame is too fast and the ranges are unreliable. A weekly range can be much deeper and the movements slower. When it comes to the best interval, I’ve found the ROC running on 10 days and the Bollinger band that overlaps running on 20 days to be ideal. Of course, it’s best to experiment on your own to calibrate it as you see fit.

Finally, and very importantly, place a reliable stop loss. Usually, the support zone will be rather evident; in the case above it is roughly at 180, where the market rebounded before.

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Source:: Profiting from an Oversold Market

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