KEY
TAKEAWAYS
- Oversold conditions create opportunities to trade with the long-term uptrend.
- Oversold conditions provide the setup, but not the signals.
- Chartists need a signal because price can become oversold and remain oversold.
There is only one way to trade in a long-term uptrend: long. Forget about picking tops and breaks below short-term moving averages. Leaning bearish within a long-term uptrend is not a profitable strategy. Instead, we should lean bullish and use oversold conditions to our advantage.
In a long-term uptrend, I am only interested in oversold conditions because these provide setups to trade in the direction of the bigger trend. I ignore overbought conditions because it is normal to become overbought in an uptrend. Oversold conditions, on the other hand, occur after a pullback and this is an opportunity to partake in the long-term uptrend.
The chart below shows SPY with two momentum oscillators: RSI(10) and %B(20,2). I am using both to identify oversold conditions in a long-term uptrend. SPY is well above its rising 200-day SMA (blue line) so the long-term trend is clearly up. %B tells us the location of the close relative to the Bollinger Bands. The indicator dips below 0 when the close is below the lower Band and this is an oversold condition. RSI becomes oversold with a dip below 30.
On the chart above, we can see %B becoming oversold in mid April, late July and last week (green shading). RSI became oversold in mid April and early August, but has yet to become oversold here in early November. On the price chart, notice that SPY is trading near its 50-day SMA (pink line). Prior dips below the 50-day SMA marked pullbacks within the bigger uptrend, not the start of a bigger trend change.
Oversold conditions are not the signal. Oversold conditions simply serve as an alert to be on guard for a short-term reversal. Keep in mind that price can become oversold and remain oversold. Chartists, therefore, need a bullish catalyst to signal a change from oversold to strength. For RSI and %B, we can use their centerlines to identify an upturn in momentum. The chart below shows these centerlines as short red lines (50 for RSI and 0 for %B). 
A bullish signal triggers when RSI becomes oversold and then breaks above 50, while a bullish signal triggers when %B becomes oversold and then breaks above 0. The green arrows show breakouts in late April and mid August. %B became oversold last week and has yet to break above 0. Thus, it is still in oversold condition. RSI did not become oversold. I would like to see both become oversold and then look for the momentum breakouts.
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Choose a Strategy, Develop a Plan and Follow a Process
Arthur Hill, CMT
Chief Technical Strategist, TrendInvestorPro.com
Author, Define the Trend and Trade the Trend
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Arthur Hill, CMT, is the Chief Technical Strategist at TrendInvestorPro.com. Focusing predominantly on US equities and ETFs, his systematic approach of identifying trend, finding signals within the trend, and setting key price levels has made him an esteemed market technician. Arthur has written articles for numerous financial publications including Barrons and Stocks & Commodities Magazine. In addition to his Chartered Market Technician (CMT) designation, he holds an MBA from the Cass Business School at City University in London.
