The New Science of Technical Analysis

Chapter 3

Overbought/Oversold

Most market analysts use indicators to identify zones of high-risk or low-risk buying opportunity. They label these areas as either overbought or oversold. Typically, they associate overbought readings with selling and oversold readings with buying. Unfortunately, such classifications are more misleading than helpful. Once again, most seemingly intelligent and rational investors overlook numerous unprofitable signals and do not conduct the research required for explanations of why they failed. For years, this had bothered me.

It was never my nature to ignore or to dismiss the numerous shortcomings and failures of a market timing approach. I could have speculated why the interpretations assigned to the buy/sell zones were invalid or lacking, but I wanted substantive evidence and I pursued it relentlessly. Unfortunately, there exists no stronger incentive for involvement than to be engaged in a personal trade that quickly becomes unprofitable. My experience trading suggests a strong correlation between actively being involved—trading your personal account and applying techniques—and passively being involved—perusing a chart and making hypothetical trades. Every unprofitable price tick in your personal account seems to inspire more determination to uncover a decision rule that would prevent similar uncomfortable situations in the future. Through a process of trial and error over 15 years ago, I was able to uncover a set of rules to follow when interpreting ...