Opinion: These stock market signs can tell you when the market is overbought or oversold

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MACD (Moving Average Convergence Divergence) and RSI (Relative Strength Indicator) rank among the major stock market indicators that traders consistently use in their analysis.

Now the weekly RSI signal for the S&P 500 SPX,
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presents less overbought conditions. After breaking above 70 early last week which was an extremely high overbought signal, the weekly RSI is at 56.66 – slightly overbought, but not at the extreme levels of two weeks ago.

When the RSI climbed to 73 a few weeks ago, that was a huge red flag. Now that the RSI is closer to 50 (ie neutral), the S&P 500 could move in either direction. If the index continues to fall this week and the RSI drops to near 30, that would signal an extremely oversold market and also a potential buying opportunity.

Weekly MACD Signals (for the S&P 500)

The weekly MACD line remained above the zero line, a bullish signal. After Monday’s fall, the MACD moved firmly below its nine-day signal line, a bearish move that reflects the change in pace to the downside. Because the MACD is a lagging indicator, it cannot tell us the future, but it shows that in the short term this bull market is in trouble.

20-day weekly moving averages (for the S&P 500)

While the 20-day moving average is important primarily for short-term traders, it is a red flag that the S&P 500 has fallen below its 20-day moving average. With the market at a crossroads, savvy traders are on the sidelines with a wait-and-see attitude. No one can predict whether the market will rebound or continue to decline.

How the RSI works

The RSI indicates when an index or a stock is overbought or oversold. Like most “bounded” oscillators, it has a reading of 0.0 to 100.0 on the graph.

The purpose of the RSI is to let you know if a market or stock is overbought or oversold and may reverse. This does not mean that the security will reverse with 100% certainty, but it does indicate that it is in the danger zone.

How can you identify when a market or a stock is overbought? Look at RSI on a weekly (or daily) stock chart. If the RSI is 70 or more, the stock is overbought. If the RSI drops to 30 or less, it is oversold. It really is that simple.

When the RSI reaches 70 and above
  1. The RSI must be 70 or more and stay above this level to generate an overbought signal. It is a clue that SPX (or another index or stock) is overbought. Tip: Sometimes indices or stocks reverse before they hit 70.

  2. As any technician knows, just because a stock or index is overbought doesn’t mean it will reverse immediately. Securities can remain overbought for long periods of time before reversing.

When the RSI drops to 30 and below
  1. When the RSI on the S&P 500 (or an individual stock) drops to 30 or below and stays below that level, it is an oversold signal. This does not mean that SPX will immediately reverse to the upside, but the possibility is increasing.

How MACD works

MACD, introduced in the late 1970s, is a trend following dynamic indicator. It helps determine when a trend and its associated momentum (ie.

Be aware that MACD is a “lagging” or “retrospective” indicator, which means its signals are lagging, but don’t let that put you off. When MACD gives a signal, it is often significant, especially if used on a weekly chart (versus the daily chart favored by short-term traders).

MACD Trading Signals

When MACD is displayed on a chart, there are two lines. The black line is called the “MACD line”. The gray (or red) line is called the “signal line”. Remember: the MACD line is the lead line, while the signal line is the delay line.

In addition, a horizontal line crosses the graph called the “zero line” (0 line). The main function of the zero line is to alert you to the main trend of the underlying price action.

At its most basic level, MACD generates four signals:

To buy: When the MACD line crosses above the zero line, it is bullish.

To buy: When the MACD line crosses above the nine day signal line, it is bullish.

To sell: When the MACD line crosses below the zero line, it is bearish.

To sell: When the MACD line crosses below the nine day signal line, it is bearish.

Note: When the MACD line and the nine day signal line move in the same direction (uptrend or downtrend), this is a stronger and more meaningful signal.

MACD histogram

One of the most powerful (but often overlooked) additions to MACD is the MACD Histogram. It is a separate program that is used to assess momentum.

The histogram is a series of bar graphs at the bottom of the stock screen. If the bars move above the zero line, it means that the underlying stock (or index) is gaining strength, i.e. momentum. If the bars move below the zero line, the stock or index loses strength.

Many newbie traders don’t realize that momentum always changes before price. This is what makes MACD and the MACD Histogram so valuable. Both indicators detect when momentum is weakening. It could also be a signal to turn bullish if the bars on the histogram move above the zero line.

Histogram signals
  1. If the MACD-Histogram bar takes on a lighter color, it means that the momentum is decreasing. It is not a sell signal; it just means that the enthusiasm for that particular stock is waning.

  2. As mentioned earlier, if the histogram bar crosses the zero line, it is a buy signal. An uptrend can develop. If the histogram bar drops below the zero line, it is a sell signal. A downtrend can develop.

False signals

Keep in mind that just because MACD is generating a buy or sell signal, or the RSI is overbought or oversold, doesn’t mean that this is a profitable trade. Like any indicator, there are false signals. In addition, it is essential that you confirm with other indicators before betting real money on any trade.

Michael Sincere is the author of “Understanding Options” and “Understanding Stocks”. He also has a blog, The Weekly Trader (www.michaelsincere.com).

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