When it comes to financial markets, there is a vast array of strategies at the trader’s disposal. Some traders look to follow trends, others try to focus their efforts on countertrends. Some trade on a long-term time frame, while others may trade on a very short time frame. Some traders will look specifically for market extremes to enter or exit the market.
Markets extremes could be defined as a market move that is atypical of the norm, or a move that happens very rapidly. This type of market behavior is often unsustainable, as markets oftentimes exhibit a tendency to mean-revert. In fact, extremely overbought or oversold conditions can potentially present some of the best risk versus reward opportunities available.
That being said, the question then becomes how to potentially identify such market extremes in order to try to take advantage of them. Below are some of the best tools available to traders to spot market extremes:
RSI: The RSI, or Relative Strength Index, is a technical momentum indicator developed by Welles Wilder. This indicator compares the magnitude of recent gains and losses over a certain time period in order to measure the speed and price change of a security or derivative price. Its primary use is to identify overbought or oversold conditions in the price of an asset. The default time frame setting for the RSI is 14 days. Generally speaking, readings over 70 could be indicative of an overbought condition, while readings under 30 could be indicative of an oversold condition.
Stochastics: A stochastic oscillator is another momentum indicator that compares the closing price of a security or derivative to the range of its prices over a specified period of time. Although the technical explanation for stochastics is a bit complicated, the general theory is that a market trending higher may see closes near the highs, while a market that is trending lower may see closes near the lows. The standard time frame used for this indicator is also 14 days. Potential trade signals may be generated when a moving average crosses over or below the current price.
Bollinger Bands: Bollinger bands were invented by John Bollinger in the 1980s. The bands typically use a simple moving average, along with price “bands” that are two standard deviations above and below the moving average. The bands can expand and contract based on market volatility, and can trend lower or higher along with the simple moving average. The indicator’s creator has come up with a list of rules to follow when using the system, however, traders can also use variations of the rules or standard settings. Extended price moves above the upper band or below the lower band could potentially be indicative of a market extreme and may be used to generate trade signals.
Although these tools may be helpful in spotting potential trading opportunities, they may carry even more weight when combined with other indicators or the longer-term price trend.
Trading market extremes can potentially provide some significant trading opportunities that have favorable risk versus reward parameters. That being said, however, traders must still exercise caution and manage risk in order to be successful. Just because a market sees an overbought or oversold extreme does not mean that it will automatically move in the other direction. In fact, markets can stay overbought or oversold for extended periods of time, which makes risk management techniques critical to trading such strategies.
There is a substantial risk of loss in trading futures, options and forex. Past performance is not necessarily indicative of future results.