Moving Average (MA) III - Oversold

Revision:
7 May 2008 - Added in AUSGROUP chart for example purposes.

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Trying to squeeze more thing out from my brain before I go temporary offline. Moving average can be used to determine oversold condition.

Most of market technicians including myself use overbought/oversold indicator such as Relative Strength Indicator (RSI), Rate of Change (ROC) etc to determine oversold condition for entry. Every high level indicator has their strength and weakness.

High level indicator:

My interpretation of high level indicator is those indicators that uses some variables in a formula to calculate end results. The higher level indicators have more complicated the formula

Just for an example, RSI. RSI uses number of days close up and down in its calculation. What if the price keep going down slowly? If the counter move down day by day, the RSI will go down as well but why this counter isn't really oversold even RSI is below 30%?

RSI flag is being formed. Weak holders keep cutting loss and the volume keep exchanging hand (refer to the above mentioned example of trader A sells to trader B, trader B sells to trader C). Weak holders are still remains in this counter staying between hope and fear. This is the reason why the selling isn't over.
Venture from last year to present. Take note how many oversold has this counter has triggered by RSI (indicated by black arrow). Divergence (1) Price vs RSI and (2) Price vs Vol occurs around Nov - Dec 2007.

SinoTechFibre triggers some RSI oversold but failed to rebound. The price keep going south ignoring all RSI signal. Imagine you bought since the first RSI signal. How many times you need to cut loss?

7 May: Added in AUSGROUP which is a recent case study. AUSGROUP has successful rebound from oversold even though there is fundamental changes. Of course, always plan cut loss price before enter.

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After showing how did RSI failed us (RSI sometimes does give us good signal. Do not abandon it.), do you still think you can use the blackbox over and over again? I remembered few months ago a lot of forumers mentioned that we can't use TA anymore during this period. I would say partial yes/no because most of the TA indicator they are using is high level indicator (blackbox) and these indicators often fail during bearish market.

Side note:

Avoid volatile market that is derived by news.

Using MA to find oversold condition (at least for short and medium term) can be interesting.

What is oversold?

Until a certain point when the selling become drastic (the price deviates 20% below MA(10)) weak holders are shaken off bit by bit. Imagine you are a retailers and your losses are 20% over 10 days of holding this counter. What will you do? Will you cut loss? Yes, it is crazy and 20% loss is really something when the market is so bearish. This is the point when retailers exit and where funds (or smart money) start to buy in.

Note:

Make sure no fundamental change during this drastic drop.

The price will starts to stablize after the smart money bought into this counter because they have to support this counter from going south (to protect their interest). However, unfortunately some of the smart money are not holding for long term so distribution can happens after the price being pushes up for some time. You have to know this.

Another thing to understand is every counter has their set of rule because the 'players' within this counter have some characteristic different from other counters, for example contra players, swing players, long term investors etc.

Moving Average (MA) II - Contra & Force Sell

I also mentioned that 5MA guide is good for day-to-day trade as 5 days are average normal contra day limit for most of the players. 5MA guide is very useful especially in bullish market.

Set 5MA and when price close below 5MA, it triggers SELL signal.

In psychological view, 5MA is average price of the 'market' within these 5 days and if current price drops below 5MA means contra players are at loss. Most of the contra players don't have cash to pick up the stock, which leads to force selling of the counter when they cut loss.

In bullish market, most of the bull flag formation does not drop below 5MA and the contra players will ride all the way by rolling over their contra holding. In this condition, price does not drop below 5MA and there will not be SELL signal for this particular stock.

Example:

It is very obvious we can use 5MA to set ROLL OVER and SELL signal for bullish market. The chart above is Lian Beng during bullish market. Now you believe even a child can win in bull market.

No point for me to post too many chart here. You can open EOD chart on yourself and experience the 5MA contra signal.

Note:

For some of the counters don't have much contra players, you need to adjust 5MA to 10MA or even 15MA for the signal.

Moving Average (MA) I - Resistance / Support

Earlier on I explained this correlation of moving average to psychological of market players to some of the forumers in CNA Market Talk forum. I think it is better for me to repost it here for the benefit of more readers. Besides, I also try to reorganize some wordings from the post. I bet a lot of readers were scratching their head when they read the post earlier.

There are a lot of message Moving Average can offers. For example, Oversell condition, Force selling, bullish/bearish etc. Today we are going to discuss about how to make analogy and interpret MA as Resistance/Support in term of market psychology.

200MA is moving average of prices of 200 trading days. It is easier to interpret as those who bought within 200 days ago. Those is a group not an individual, you can also interpret it as 'market'.

When the price was below certain MAs, MA line serves as resistance. In psychological sense in stock market, this MA line for example 200MA is average prices for the 'market'. So if the current price is below 200MA and you bought within this 200 days, you suffer losses.

So when the current price is approaching the MA line (resistance) which is the break even price for those who bought within 200 days ago, you who bought earlier tends to sell when price break even. That's the reason why resistance is there to break. Especially for larger/longer moving average span, the resistance will be greater. Why? This is because the longer you wait, the more eager you wanted to sell off at break even price and secondly, there are more 'players' involved for longer MA span.

For instance, 50MA is weaker than 100MA and 200MA is stronger than 100MA.

So how does volume affect them?

It is an undeniable fact that volume means support to that particular price which is something like 'acceptance' for the price. The bigger volume means a larger portion of the market is accepting this price is reasonable for this particular counter for that particular day/session. That's why the volume grows when we are near bottom when more and more people is accepting the price of a particular stock.

Breaking out resistance with high volume does gives us more confidence. Yet, we need to consider throw backs too. When a break out is weak, throw backs can happens and at the worst case is false break out.

When price break through resistance, it needs to sustain to confirm the break out. Until then you who is one of those who bought within this 200 days start to become bullish (greedy). When the break out is more convincing, more 'players' will be joining in the boat.

MA as support is something opposite from what I mentioned above. Do you still need explanation? I guess I leave it for you to interpret yourself.

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Side notes:

Many TA practitioners used tons of special indicators in doing analysis. I am not saying that those indicators are useless but a lot of amateurs believe they are holy grail, magic black box that can produces BUY/SELL call immediately. I asked a lot of TA practitioners before, most of them don't even know what is the formula behind these indicators at all. Most of them analyse based on convergence and divergence theory.

Personally I still think that Price, Volume and Moving Average has a lot of message/clue for us and is one of the best indicators if we use them correctly.

The only problem is how to apply them because it is too subjective and could produces different results. I think the only way is to use them over and over again you got them mastered.