Abnormally Overbought Is Not Bearish

Often the market will trade in one direction until it reaches an overbought or oversold state. Professional traders tend to fade an overbought/oversold market while rookies will buy/sell in the direction of the short-term trend.

More rare are the times when the market exceeds a standard overbought/oversold state and trades itself into abnormality. When this happens, the standard measures of overbought/oversold tend to fail. Traders can get hurt in an abnormal market if they keep fading it.

By at least one measure, we find the current market in an abnormal state. And this is why I was surprised to see Bespoke’s article that seemed to suggest that a sharp pullback was near. Granted, I’m not a premium subscriber so I was not able to read the entire article.

When measuring for abnormality on the S&P 500 (especially in terms of mean-reversion), I use Bollinger Bands built around a 50 day average with the top band 2 standard deviations above the mean. Oddly enough, these are the same settings Bespoke is using. I use an asymmetrical setting for the bottom band.

Here is how I use this measure: If the S&P 500 closes above the top band, it forces any open shorts to be closed. No new shorts are opened as long as it continues to trade above the top band. This is a binary approach. One could also reduce position-size for shorts as the S&P 500 gets closer to the upper band, with size becoming zero as it crosses the upper band.

Why do I do this? Let me demonstrate…

Buy Rule: Buy the close when SPY closes above the upper Bollinger Band (50,2).

Sell Rule: Hold this trade for X days, selling at the close.

All SPY history was used. All trades are frictionless.

The Results:

The left axis is the Avg. % Profit/Loss and the right axis is the % of Winners.

• Holding 1 day made 88 trades. Holding the maximum 50 days made 37 trades.
• There is some mean-reversion that happens after a close above the upper band. It peaks around day 6. However, the average trade barely goes into the negative.
• The average trade peaks ~8 weeks later at ~2% gain.
• The mean-reversion is shown most clearly in the % of Winners, which falls beneath 50% around day 6.
• The % of Winners peaks several times near 70%, with its highest peak of ~72% arriving nearly 8 weeks after the entry.

Summary:

This is not a setup that will make one rich going long. It is, however, a setup that may keep one from going broke while shorting an abnormally overbought market. While a pullback is likely over the next week, it is not likely to be very deep. System traders are urged to develop their own measures of abnormality.

MySimpleQuant gave a very similar treatment to this issue yesterday…Check out his results.

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