How to Spot Overbought Stocks That are Due for a Drop
This handy indicator finds stocks that are about to reverse course. Here's how to screen for them in TradeSmith Finance
How to Spot Overbought Stocks That are Due for a Drop
I just love getting questions and feedback from Inside TradeSmith readers. When I can cover the topics you want – or provide clarity on something I've covered before – it really helps me decide what to discuss in my next column.
Here's one email I got that's especially relevant to the latest market action:
The "Oversold" query of 10/31/23 got me thinking, has he given us a query for "Overbought" stocks? (Thinking that perhaps I should sell some of my overbought portfolio while it "reverts to the mean"). I'm enjoying your data-driven approach!
That's a terrific question, and the answer serves as a timely topic for today's column, considering how overbought stocks have become in general.
For my money one of the best ways to find overbought stocks is by using the relative strength index (RSI), a technical indicator we feature in TradeSmith Finance. Better yet, you can also use this widely followed indicator to spot oversold stocks, too.
Developed by J. Welles Wilder and published in his 1978 book, "New Concepts in Technical Trading Systems," RSI has become one of the most popular technical indicators.
The RSI provides signals that tell investors to buy when an asset is oversold and to sell when it is overbought. It helps you to track the current and historical strength or weakness of a stock or index based on the closing prices of a recent trading period.
RSI is classified as a "momentum oscillator," measuring the velocity and magnitude of price movements. In other words, it charts the rate of change in the rise or fall in price.
Specifically, RSI computes momentum as the ratio of higher closes to overall closes: stocks that achieve more or stronger positive closes have a higher RSI than stocks that have had more or stronger negative changes.
The RSI is most typically used on a 14-day time frame, measured on a scale from 0 to 100, with high and low levels marked at 70 (overbought) and 30 (oversold), respectively.
The trend in RSI, either up or down, reflects the trend in a stock or index. High and low levels (above 80 and below 20) appear less frequently but indicate stronger positive or negative momentum.
Wilder found that when RSI bottoms below 30 or tops above 70 it can provide useful buy or sell signals, respectively. Levels in between these extremes indicate the strength of trend, with the 50 level considered neutral.
Wilder also pointed out that divergences between RSI and price action can provide strong indications of a turning point, or a coming change in trend.
A bullish divergence occurs when price makes a new low, but RSI makes a higher low. And a bearish divergence takes place when price makes a new high, but RSI makes a lower high.
Armed with this understanding of how RSI works, we'll use the TradeSmith Screener tool to create our own overbought/oversold stock screen, using RSI along with some proprietary TradeSmith indicators.
The Screener is available to anyone with access to Ideas by TradeSmith. I'm also using our Trade Cycles indicators. (Note: my Screener may look a little different from yours since I have Platinum-level access.)
Setting up your Filters
Be sure you are signed in to TradeSmith Finance. Click on the Invest menu at the top, then the Screener tab. First you'll see a few pre-built TradeSmith screens that you may want to explore later.
For now, click on + Create new screener, then + Manage Filters.
Under the TradeSmith section, check Relative Strength Index, Cycle Conviction Level, Cycle Turn Area, and Cycle Period.
Next, under the General section, click on Markets.
Then click the Save & Close button.
To give yourself a cleaner view, back on the + Create new screener page, click the trash can icon to remove any filter line you don't plan to use.
Now let's review how the filter settings look within the platform.
Fine-tuning the Filters
For Markets, I chose the large-cap S&P 500 Index to keep it simple, but you can select other indexes to include more stocks in your screen.
Set the RSI to more than 70 to find any overbought stocks in the index.
Next, for added conviction, I included our proprietary Trade Cycles timing indicators. Here are my settings.
For Cycle Turn Area, use the dropdown menu to select Upcoming Peak and Peak.
Under Cycle Period, select the Composite Cycle, which is a blend of all the various timing cycles we track.
And for Cycle Conviction Level, I chose Medium, High, and Very High – I excluded Low. That's because I wanted a greater degree of confidence that the stocks on this screen would be at or near peak price trend.
RSI is a powerful and proven indicator on its own, no question, but by including our timing cycles, we can have more conviction that these stocks are at a possible overbought top and due for a trend change to the downside.
Now, be sure to save your work by clicking on Save As New so you can revisit this screen later. When I ran this screen, I found 95 S&P stocks that are overbought. Due to limited space, below is a screen shot of the top 10.
Filtering for Oversold
Now, you can easily turn this stock screen on its head, so to speak, in order to quickly find oversold stocks. Adjust your settings like this:
Set the RSI to less than 30.
For Cycle Turn Area, use the dropdown menu to select Upcoming Valley and Valley.
Stick with the same Composite Cycle period and Cycle Conviction Level of Medium, High, and Very High.
These settings should help add conviction that stocks making the cut are not only oversold per RSI, but they're also at or near a valley low and expected to turn higher in price.
When I ran the oversold version of the screen, I found just one S&P 500 stock made the list.
Using both versions of the RSI screener (overbought and oversold) in this way delivers an added bonus. It tells you at a glance that the S&P 500 overall is much more overbought today than oversold. And that's a useful market timing indicator on its own!
Mike Burnick's Bottom Line: In my own experience trading stocks for nearly four decades now, I can tell you that RSI is one of the most useful technical indicators. That's why we feature it in our Screener filters. And by saving and periodically running the above screens, you can see which stocks are overbought or oversold.
Happy New Year! And keep those emails coming, folks, at emailmikeburnick@tradesmith.com. Please include "Inside TradeSmith" in the subject line when you write in.
Good investing,
Mike Burnick Senior Analyst, TradeSmith
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