The stock market has often been a place that scares new and seasoned investors alike, with fluctuations of daily change, significant dips and spikes, and it can be tough to come up with clarity in determining whether the market is “oversold” versus just down on a short-term scale. It becomes very unclear, and thus poor decisions are made on falsely based assumptions.
In this video, we will speak about the concept of an oversold condition in the market, especially with respect to the fact that using statistical tools such as the Relative Strength Index. Knowing when the market is actually oversold can give much information to traders and investors in their decisions. We will go ahead and backtest a simple but powerful trading strategy to show how this concept of an oversold condition can be utilized to give way to superior returns.
Knowing that the mean reversion principle exists and being on the lookout for conditions that might make a stock or index unduly oversold opens for you the door to a systematic way of trading and investment. We will take a walk through a backtest of a strategy that bought the S&P 500 when the three-day RSI fell below 20, then sells at some fixed time, in order to see how oversold conditions might betoken positive returns. Whether you’re a speculator looking to make profits in the near term or an investor searching for superior returns of the longer term, it’s an important notion to own if you are going to be at the top of your game in the market
What Does “Oversold” Mean in the Stock Market?
Oversold” in the stock market refers to an asset which has been subjected to way too much selling, and thus, its price had dropped sharply and decisively. Typically, this condition develops after the asset has traded on some form of strong downsides movement for some period of time and may even trade a stock or a market below its intrinsic value. Under such conditions, it could be assumed that a stock, index, or asset has fallen too low and needs to rebound.
Although the word “oversold” is somewhat subjective, probably the most commonly cited gauge in such situations is the Relative Strength Index, or RSI. RSI is a momentum oscillator that measures speed and change in price movements. An RSI below 30 typically indicates that it is an oversold condition, and odds favour that there will be a future buy into the market.
Key Concept: Mean Reversion as a Tool for Understanding Conditions That Are Oversold
The term “oversold” makes sense only if one understands the mechanism of mean reversion-the statistical phenomenon describing price actions and tendencies to rebound towards a more normal average or “mean” level once it deviates significantly from it. The phenomenon occurs because markets aren’t perfect. They tend toward sharp deviations from the trend and correct over time.
When stocks or indexes grow oversold, this often means only that the marketplace has reacted too vigorously to terrible news by lowering prices so far that they now stand below their intrinsic values. Historically, markets rebound from these conditions when there was no fundamental basis for prices to fall (such as a recession or a crisis in the market). It’s where mean reversion takes over: following a large decline, the market would tend to rebound back up to its average.
The role of RSI in determining the over-sold conditions would be Of all the tools that signal an oversold and overbought condition, the Relative Strength Index or RSI is still the most widely used indicator. The RSI is a momentum oscillator with values ranging between 0 and 100, where a reading above 70 means an overbought condition, and below 30, the market is getting oversold. In fact, when the RSI level drops below 20, it has generally been interpreted as a good signal that an asset or index may be getting oversold.
Let’s take an example to illustrate this:
Imagine the S&P 500 index goes sharply down for a few days, and the RSI crashes below 20. This will give traders and investors applying the RSI a buy signal as it indicates an over-sold condition sure to bounce.
Testing an Oversold Strategy Using Real Data, Real Results
In investigating trading with a market when it comes to be believed to be oversold, consider a simple backtest to an RSI-based strategy. The rules for this strategy are as follows.
Bullish on S&P 500 at close: Three-day RSI ≤20
Sell S&P 500 at close: N days after initiation based upon performance.
This strategy is premised on the theory that the market always bounces back after becoming over-sold, thus, purchase at the point of maximum weakness can bring considerable return over the long haul.
Backtest Results
After some testing of this strategy, the following emerged as quite impressive:
- Beginning Equity: $ 100,000
- Ending Equity: $ 1.3 million at test end
- Average Annual Return: 9.14%
- Time Invested: 16.8% of time
So the big takeaway is that this is extremely risk-adjusted return. Only being used a fraction of its time to-date has allowed this strategy to return 9.14% at least several orders of magnitude better than random market movement in which one may expect a little over 0.04% per day on average. Another aspect is that the equity curve was fairly smooth and pretty step-like in nature with minimal drawdowns, hence this strategy was not only profitable but rather robust to all aspects of market volatility.
Why Does This Strategy Work?
It works because this strategy actually plays off the natural tendency of markets to mean revert. Once declines in the market become severe enough in the direction downward, they reflect oversold conditions and that’s likely to reverse. The RSI helps pinpoint those moments by quantifying the velocity of price changes and pinpointing points where the market is exceedingly weak.
Buying when the RSI is low (below 20) puts the strategy in the market at an “oversold” time, and the probability of a rebound is high. Selling after some number of days allows the strategy to capture the upward price movement as the market reverts toward its mean.
What Returns Can You Expect from an Oversold Market?
We discovered through our backtest that trading at oversold with the assistance of such tools like RSI produces returns above averages. In point, we observed the following during our backtest:
- Higher Returns: The backtest was generating a consistent annual return at 9.14% even when investments are held for just 16.8% of the time.
- Lower Risk: The strategy had low levels of drawdowns with good risk-adjusted returns. It only meant that this strategy gave them solid returns without putting the investor at dangerous levels of risk.
Proper market timing. Whenever an RSI hits such oversold conditions, it is capitalized upon to ride the waves of mean reversion. With such, the assets would be bought during the depressed prices then sold once those assets recover.
Conclusion: How Oversold Conditions Lead to Success in the Stock Market
Knowing when the market has oversold is going to be really important for whoever wants to maximize returns and minimize risk in their way. The tools used here are the Relative Strength Index, or RSI, which will let investors time their entries more appropriately by looking at buying prices when they go low and thereby position themselves for a rebound of the market.
Our backtest results are clear: using this strategy that’s based on oversold conditions allows you to get higher returns, even within relatively short periods of investment. The secret lies in knowing the signs of being oversold and riding mean reversion in your favor. Unlock the secret to guaranteed stock market success and increase your possible investment returns in the process.
The next time the market is having its dip, you might resort to using the RSI in checking oversold conditions. When the numbers are aligned, you could, after all, just be entering at the right time to ride the wave to potential recovery.