How to Trade Extremes In Market Breadth (Above the 50)

Above the 50 logo: overbought and oversold
Above the 50 logo: overbought and oversold

{As of July 29, 2021, I have switched to a new breadth indicator called “Above the 50“. The discussion below remains relevant. I plan to make edits for clarity in the coming weeks}

AT50 is an abbreviation of “Above the Fifty.” I use the term to refer to MMFI in which is a measure of market breadth. MMFI quantifies the percentage of stocks trading above their respective 50-day moving averages (DMAs). Extremes in AT50 define overbought and oversold stock markets. On July 29, 2021 I made the switch from T2108 as AT40, or above the 40DMA to AT50. I used a correlation analysis to transfer the overbought and oversold thresholds from AT40 to AT50.

A primer on Above the 40 (AT40) as a measure of market breadth – my previous indicator of market breadth.

Overbought and Oversold

I use AT50 to flag short-term “overbought” and “oversold” conditions in the stock market. Given the short-term nature of the analysis, T2108 mainly provides trading signals for swing traders. Long-term investors can use AT50 for timing buying opportunities to add to existing portfolios.

Overbought defines a market condition where buyers have crowded into a trade. There are few new buyers or new sources of funds to keep pushing a stock or index higher. Conversely, oversold defines a market condition where an extreme of traders and investors exit a stock or index. The remaining holders are the ones who are not willing to sell at the existing price. In these cases, trading becomes over-extended in one direction and odds favor some kind of reversal. When buying power exhausts itself, the path of least resistance goes to the sellers. Think of traders who want to lock in profits. When selling power exhausts itself, the path of least resistance goes to the buyers. Think of traders salivating at current prices as incredible bargains.

I consider the stock market overbought when AT50 trades above 72%. When AT50 trades below 21%, I consider the stock market oversold. In each case, so many stocks are above/below the threshold that little extra room exists for more buying/selling. In other words, as AT50 continues higher from the overbought threshold, buyers find fewer and fewer stocks at attractive prices. When AT50 continues lower from the oversold threshold, sellers are less and less interested to give up at low prices.

Trading Rules for Overbought and Oversold Stock Markets

I developed short-term trading rules from these basic observations (really principles). When the stock market is overbought, a trader typically should avoid initiating new long positions. A trader should start closing out existing longs, and consider opportunities to go short. When the stock market is oversold, a trader typically should avoid initiating new short positions. A trader should start closing out existing shorts, and consider opportunities to go long.

These trading rules are foundational, yet I always review the potential unique circumstances for any overbought or oversold period. I make these caveats clear in the prior T2108 Updates and the updated market breadth series using AT50. I write to describe trading conditions. For example, the 2008-2009 financial crisis introduced an era of active central bank intervention that profoundly impacted on stock markets. Ample liquidity helps produce what I call “extended overbought rallies”. In these cases, the stock market remains overbought for many days and sometimes weeks. I now generally recommend bearish trading strategies only AFTER AT50 falls from overbought conditions.

Use and Validation of T2108

Traders should use AT50 as a strong complement to existing trading tools. For example, if the market is oversold, a trader might wait for a climactic sell-off, like a “hammer” candlestick, before making bullish trades. When the market is overbought, a trader might wait for a “blow-off top” before going short.

The Origins of AT50 as Market Breadth: the T2108 Trading Model

Over the years, I validated the T2108 thresholds as sufficiently definitive as trading signals. Starting in April, 2013, I began a complete overhaul of my usage of T2108 for trading that I called the T2108 Trading Model (TTM). In TTM, I used machine learning methods to project the likely performance of the S&P 500 depending on the number of days that T2108 spends above or below a threshold (and the performance of the S&P 500 during that time).

I also used machine learning methods to determine the odds of the S&P 500 bouncing back from at least two straight days of “intense” selling; a condition I call “quasi-oversold.” This modeling effort generated my first exhaustive compilation of T2108-related data and relevant relationships. On December 29, 2014, I implemented the first update of these data and analyses. Interested readers can click here to download the presentation (feedback welcome!).

I produced several refinements to the trading rules for T2108 – some pre-overhaul, some post-overhaul. I have also refined strategies depending on the context of the trading environment. Here is an updated list of the most important posts and their high-level trading rules listed in reverse chronological order with the most important posts listed in bold. As of September 3, 2021 I have not yet launched a series using AT50. Still, all the above content remain relevant to traders interested in using market breadth in their work.

T2108 Data Refreshes

  1. S&P 500 Performance During Overbought and Oversold Trading Conditions” (January 31, 2019): An update on T2108 historical data, durations of oversold/bought periods, mean/median durations, and the performance of the S&P 500 during oversold and overbought periods.

Trading Overbought Conditions

  1. Key Overbought Signal Hit Historic Highs – A Bullish Sign For Stocks” – Seeking Alpha (June 9, 2020): Each period featuring 90%+ share of stocks trading above their respective 40DMAs featured a bullish rebound from a market sell-off, crash, and/or recession with the year ending with additional gains.
  2. A Bearish Reversal for the Stock Market” (June 10, 2016): T2108 fell out of overbought conditions in dramatic fashion and created a bearish trading signal.
  3. Overbought Status Finally Ends As the NASDAQ Teeters” (May 3, 2016): The end of an overbought period created a bearish trading signal.
  4. New Trading Rules After Market Ends A 414-Day Overbought Drought” (March 1, 2016): A COMPLETE review of the trading rules for overbought conditions.
  5. A Toppy Feeling In the Market Even As Individual Stocks Shine” (November 6, 2015): An example of the bearish signal created from a failure of T2108 to crack into overbought territory even as the S&P 500 continued to make (marginal) gains.
  6. Overbought for A Hot Minute With Breakout Charts Galore” (November 21, 2014): Created conditional rules: bearish if the S&P 500 confirms a pullback from overbought conditions; bullish and buy the dips if the S&P 500 extends into overbought territory.

Trading Oversold Conditions

  1. The Latest Oversold Period Ends With A JP Morgan Chase Bottom” (February 12, 2016): A COMPLETE review of trading oversold periods that includes using the volatility index, the VIX. This piece also looks at the difficulties presented by the frequent recurrence of oversold periods.
  2. A Second Epic Oversold Period Over the Past Five Months” (January 20, 2016): T2108 makes a VERY rare drop into single digits, and I use the VIX AND currencies to help assess the trading opportunities for bottom-fishing. I included a very detailed list of trades at the time.
  3. How To Profit From An EPIC Oversold Period” (August 24, 2015): A drop into single digits for T2108 in the wake of what turned out to be a flash crash. I provided detailed trading strategies for aggressive and conservative traders based on movements in the VIX and other signals.

Article Archives

Here is an archive of older studies form which I built most of my latest strategies. These studies still have relevance as historical analyses, but they are no longer “required” reading. (I still review them from time-to-time)…

  1. Trading Strategies for an Overbought S&P 500 Using the Percentage of Stocks Trading Above Their 40DMAs (T2108) – an update to a similar analysis January, 2009, see below (November 6, 2011)
  2. Trade the Oversold Bounce (PDF file) – written for SFO (Stocks, Futures and Options) Magazine as a follow-up to my 2008 article discussing trading strategies using oversold indicators from T2108 and the VIX. (July, 2010)
  3. Using the Percentage of Stocks Trading Above Their 40DMAs (T2108) to Identify Overbought Conditions on the S&P 500 (January 4, 2009)
  4. Does the VIX Need to Spike at A Climactic Low? – Using T2108 and the VIX (July 7, 2008)

I also actively use T2107, the percentage of stocks trading above their respective 200DMAs, as a check on longer-term trends. I have not established low or high thresholds on T2107. On June 10, 2016, T2107 broke out of a post-recession downtrend in what looked like a bullish breakout. That breakout did not last long! (Click here for a definition of the “T2” series of Worden’s Market Indicators)

If you still have questions about T2108 or about using it for trading, feel free to contact me directly. I also highly encourage readers to subscribe to the email distribution list for this blog to get timely updates.

Be careful out there!