We have all heard the term overbought, and occasionally you might hear the term oversold. The big question becomes what defines a market as either overbought or oversold. Looking at the recent history of the market, you may have heard the criticism of the 4th Quarter of 2011. It was a very powerful quarter, many viewed that quarter as overbought. I’m not going to engage in a debate, or even a dialogue as to whether it was or not, but what defines that. Typically you would expect an overbought market to be moving higher. At least, that makes sense to me. Consider though that the 4th quarter of 2011, was also the end of 2011. If we look at the E-Mini S&P 500 for that time period, we see some disparities
In the 4th Quarter view you see a market rallying from the lows of the year, and the rally was indeed impressive, so the viewpoint that the 4th quarter was overbought is valid. However, from the viewpoint of an annual market, that kind of takes a backseat. In 2011 the ES lost 3 points from its open, and did it in a market that had a 305.50 point range. Put in perspective, the change in the market of 2011 was about 1% of its range. The total change in the market of 2011 was -0.24%, and yet many experts emphatically believed the market was overbought. Those same percentages in the 4th quarter though were just a bit different. The range was 221.25. The market rallied 130 points from the open. That means the change in the market was about 58% of the range. That constitutes a high number. Of even greater import though, the 4th quarter was up 11.5% from open to close. Comparing the quarter to the year has given us drastically different numbers, and these numbers give us drastically different views of the market.
This is where the use of statistics can become a bit dicey. What is it that we are trying to prove. If I am trying to prove the overbought nature of the market, I’ll show you the 4th quarter. If I am trying to prove to you a stable market with very little change, I’ll show you the year. This is where numbers clash. Both viewpoints are valid. So we need to be able to look at both, and see that they do indeed clash. This gives us perspective on what we are trading. Not the perspective we want to see, but the perspective being indicated by the market. The solution, we should be aware of the strength, and possible overbought condition of the 4th quarter, but we should also have the perspective to see the bigger picture. It would have been a shame to miss the 1st quarter rally of 2012. It would have been a bigger shame to miss it because we were only seeing what we wanted to see. Numbers will, and do clash. The smart trader sees the clashes, and understands the potential for them, and goes into trading with an open mind. After all, even if you accept that a market is overbought, there has never been any rule written stating it cannot remain overbought.