Rapidly Approaching Oversold Levels: RSI < 30 What’s Next?

• Posted by DynamicHedge
• on October 9th, 2013

One decent way of measuring overbought and oversold conditions is through the RSI indicator. A reading above 70 is considered overbought and a reading below 30 is considered oversold.

The market is rapidly approaching oversold levels and we want to know what this means for price performance.

We’ve pulled every instance of the $SPY entering oversold conditions since mid-2008. Each instance of the market entering an oversold condition is highlighted in light blue.

Now let’s request a 20-day post-oversold analysis period. The analysis period is shown in the grey shading:

Question: Is it a good idea to buy oversold conditions?

Let’s look at the statistics table:

With 73% of the trades ending in profit after 20-days and a statistically significant profit, the conditions looks favorable for the long side.

The problem is the a statistics table only shows us part of the picture.

The most important question is ALWAYS risk management. How do we know if the trade is good and when it is potentially going wrong?

For that, we’ll turn to the Alpha Curves.

The four most dominant patterns which make up the Alpha Curves for this scenario look like this (NOTE: The vertical line divides data that is “in-sample” or “known” to the left, and the analysis period, or “unknown” to the right).

Pattern 1: A straight shot relief rally. The most favorable outcome for a long is also the most dominant pattern in the dataset. Nice.

Pattern 2: The trade works initially for a pop, but after 8-days it breaks down and makes new lows. Be on guard for cutting losses quickly.

Pattern 3 & 4: Choppy bottoming process followed by a relief rally and then more chop, ending nearly unchanged. Significant new lows before the relief rally means sell the rip.

Conclusion

The trade is a good one but nothing is a slam dunk.

The most dominant pattern works in a clean and methodical way. The second most dominant pattern works for a bit and then continues lower. These are the harsh reality of market returns. The point of these tools is to give traders a realistic visualization of how the various scenarios unfold so that you can recognize and react in real-time.

 Hopefully between the statistics table and the Alpha Curves we’ve illustrated the key payoffs and risks associated with buying oversold conditions.

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