{"id":1818,"date":"2010-05-25T03:02:15","date_gmt":"2010-05-25T07:02:15","guid":{"rendered":"http:\/\/drduru.com\/onetwentytwo\/?p=1818"},"modified":"2010-05-25T22:56:13","modified_gmt":"2010-05-26T02:56:13","slug":"oversold-conditions-persist","status":"publish","type":"post","link":"https:\/\/drduru.com\/onetwentytwo\/2010\/05\/25\/oversold-conditions-persist\/","title":{"rendered":"Oversold Conditions Persist Even As Volatility Reverses"},"content":{"rendered":"

Until the ugly close on the stock market, Day #4 of this oversold period was as lackluster as I expected. T2108<\/a>, the percentage of stocks trading above their respective 40-day moving averages (DMAs), nudged up a bit to 11.7%. For a while there, it seemed as if the latest dire headlines from Europe<\/a> – this time Spain raining on the parade with its latest banking woes – would not take the the U.S. stock market down.<\/p>\n

It was a day that allowed me to get my fill of oversold stocks for playing the next bounce (see “Bullish Trading Opportunities Emerge from the Carnage<\/a>” for my rationale and caveats). Despite the day’s ugly close, volatility (the VIX) declined, likely confirming the topping signal printed with Friday’s bearish engulfing pattern. This action should provide a small amount of solace for those of us making bullish plays here.<\/p>\n

Trader Mike summarizes the trading dilemma quite well<\/a> (emphasis mine – see the recap for his descriptive charts):<\/p>\n

“It\u2019s been a choppy last few sessions but the daily charts show some clear resistance forming at last Thursday\u2019s gaps on the indices. You can also see a bull\/bear battle for control of the 200-day moving averages on the Nasdaq and S&P 500. The price action today should have been discouraging for the bulls. They should have been able to make more progress after Friday\u2019s surge but the volume and price action today makes me think that Friday was mostly about shorts getting out of the way in case peace & prosperity broke out over the weekend. If we weren\u2019t already so oversold I\u2019d be chomping at the bit to get short under today\u2019s lows with a stop at today\u2019s highs. I\u2019m also a bit hesitant because, assuming the flash crash lows hold again, the risk\/reward isn\u2019t that appealing.<\/strong> So I may try one or two shorts tomorrow if this afternoon\u2019s weakness carries over tomorrow but I\u2019ll be quick to cover if it looks like we\u2019re gonna bounce off of those lows again.”<\/p><\/blockquote>\n

The overall technicals on the market are ugly and continue to worsen<\/a>, typically ideal conditions for shorting. However, the longer this oversold period lasts, the more likely the market will experience a sharp bounce on even a whiff of good news. Bulls cannot get too excited over such a bounce because of all the overhead resistance, the steep short-term downtrends, and the constant stream of negative news flow that is shrinking an already small pool of motivated buyers. Most troubling of all is the continuing worsening of global credit conditions<\/a>, mirroring the credit troubles of 2008.<\/p>\n

I chose to play this one long because I would not want to get caught net short down here (I am still holding a handful of June puts), and the bullish engulfing patterns from Friday were so convincing to me. If you read my post analyzing Friday’s action<\/a>, you know that I tried to increase my odds of success by applying some strict filters on stocks that met the criteria for the potential reversal pattern. In particular, I divided up the stocks into five tiers based on their positions relative to their respective 50 and 200DMAs. So far, the strongest stocks (“Tier 1”), those that closed above their respective 50 and 200DMAs on Friday, have generally out-performed the stocks in the remaining tiers – as we should expect. However, these remaining tiers have not provided any additional insight into how to trade these current oversold conditions from the long side.<\/p>\n

As a reminder, here are the tiers:<\/p>\n

    \n
  1. Tier 1<\/strong>: closed above the 50DMA and the 200DMA and never crossed the 200DMA (41 stocks)<\/li>\n
  2. Tier 2<\/strong>: successfully tested the 200DMA support. Thursday\u2019s selling did not break the 200DMA whereas Friday\u2019s action took the open or the low of the day below the 200DMA. (14 stocks)<\/li>\n
  3. Tier 3<\/strong>: closed on Thursday below the 200DMA and closed above it on Friday. (40 stocks)<\/li>\n
  4. Tier 4<\/strong>: traded above the 200DMA but never crossed the 50DMA which remains overhead (104 stocks)<\/li>\n
  5. Tier 5<\/strong>: traded below both the 50 and the 200DMA (129 stocks)<\/li>\n<\/ol>\n

    The table below describes the simple analysis I conducted on the tiers to tease out some insights. “The range” equals the percentage increase from Friday’s low to the close (relevant because of the bullish engulfing pattern). “The next day change” equals the percentage change from Friday’s close to Monday’s close. The strength of the bullish engulfing pattern had little to no correlation with price performance the next day. Tier 1 was the least correlated of the tiers, but stocks in this tier tended to perform better during Monday’s selling than the remaining tiers. Since I focused on stocks in this tier, I am hoping that these statistics point to out-sized gains in the coming days.<\/p>\n

    <\/p>\n