Finding oversold and overbought stocks that are ripe for a reversal can be a profitable trading strategy. While many investors focus on buying and holding stocks for the long term, technical analysts look for short-term opportunities to capitalize on swings in a share price.
Although the core of my portfolio consists of long-term holdings like Tesla, I occasionally use options to trade individual stocks that exhibit an extreme overbought condition or oversold condition, thus signaling a potential turnaround.
There are several technical indicators to identify exhausted trends, but the ones I have found most useful are the Relative Strength Index (RSI) and the Sequential and Combo indicators developed by market timing legend Tom DeMark.
The RSI indicator is a bounded momentum oscillator that quantifies whether a stock is overbought (with an RSI above 70) or oversold (with an RSI below 30). DeMark’s Sequential indicator shows the maturity of a trend, and the Combo indicator triggers actual buy and sell signals.
In this article, I will explain how I use the RSI in conjunction with DeMark indicators to spot imminent reversals. Tuning into these exhausted trends at inflection points allows me to profitably trade options around my core long-term holdings.
What is the Relative Strength Index?
The Relative Strength Index (RSI), sometimes called the Relative Strength Indicator, is one of the most common momentum oscillators developed by J. Welles Wilder in 1978 to measure the velocity and magnitude of directional price movements.
The RSI provides a normalized scale from 0 to 100 for identifying an oversold stock or an overbought stock. The calculation compares the magnitude of recent gains versus recent losses, with values above 70 indicating an asset is overbought and may be primed for a pullback, while values below 30 indicate an asset may be in the oversold zone and due for a bounce.
The RSI is especially useful for identifying divergences from price trends and spotting potential reversals early. For example, when a stock price is making new highs but RSI is failing to exceed its previous highs, it signals the uptrend may be losing strength and the momentum is waning. The opposite divergence happens at market bottoms.
As the RSI oscillates between overbought and oversold levels, it provides trade signals on countertrend bounces or entries in the dominant direction. Using the RSI in combination with other indicators provides further confirmation for major trend changes. With its flexibility and clear signaling, the RSI is one of the most popular indicators used by traders today.
What are the Sequential and Combo Indicators from Tom DeMark?
The Sequential and Combo Indicators were developed by Tom DeMark in the 1970s. These are advanced TA tools used primarily by technical traders to predict potential price reversals in various markets, including stocks and cryptocurrencies.
The DeMark Sequential indicator is a 13-count indicator that identifies potential reversal points in the market. It’s based on the premise that as a trend progresses, it becomes more likely to reverse. The Sequential indicator works in two phases: the setup phase and the countdown phase. The setup phase occurs when a series of nine consecutive closes are all above or below the close four bars earlier. After the setup is complete, the countdown phase begins, requiring 13 closes either higher or lower than the high or low two bars earlier. When this countdown is completed, it suggests a high probability of a price reversal.
The DeMark Combo Indicator is similar to the Sequential Indicator but has a different set of rules and a shorter timeframe. It’s designed to identify more trading opportunities by being less strict than the Sequential Indicator. The Combo indicator also combines setup and countdown phases but with slightly different criteria and a focus on shorter-term trading signals.
Both the Sequential and Combo indicators are known for their complexity and typically appeal to more experienced traders who are adept at interpreting sophisticated technical signals. They are often used in combination with other technical analysis tools to enhance the accuracy of predictions.
Using RSI with Tom Demark Indicators: MARA
A friend recently asked if I thought Marathon Digital Holdings (MARA) was due for a pullback after its strong price run-up. As Bitcoin rallied to local highs, MARA and other publicly traded crypto miners rode its coattails higher. Indeed, here in late December, all of crypto seems to be in an overbought market.
So let’s look at the stock chart for MARA and see what it tells us. In the chart example below, we see the daily chart for MARA with the TD-Combo and RSI indicators applied.
Note, that the RSI level peaked at 79.9 on July 13. This signaled the price movement had turned overbought. This preceded a sizable trend reversal, as MARA declined until early October when its RSI readings reached oversold levels of around 25.
As the downtrend unfolded, TD Sequential printed two completed countdown signals as denoted by the sequential red number 13’s. These highlighted possible market turning points.
The first created an immediate price bounce, with a stunning 28% candle on August 29. But this rally was short-lived, with the second set-up and countdown phase completing soon after.
With the completion of the second countdown phase, and with the RSI touching 25, the indicators suggested MARA had become an undervalued stock. The Bitcoin miner had entered an oversold market, and late October represented a good buying opportunity.
Since mid-November, MARA has moved in the opposite direction, rallying three-fold in a nearly uninterrupted advance. Now, as of December 22, the RSI is back in overbought territory with a reading above 88. Furthermore, TD Combo has already registered one completed setup/countdown sequence and has now initiated a second setup phase.
Hence my friend’s question: is it a good idea to buy puts on MARA?
I suspect that on Tuesday, December 27th—when markets reopen following the Christmas holiday—MARA could complete the current setup phase i.e. a second green 9 will print on the daily chart.
The concurrent RSI extreme increases the odds that the next session will mark the start of a reversal. Sometimes, reversals begin upon the completion of the set-up phase (hence longer-dated put options here might not be a bad idea). Still, allowing the full setup to complete provides the highest probability.
Sometimes, a higher timeframe provides more clarity. Let’s look at MARA on a weekly time frame. Here is that chart below.
Here, the weekly RSI is similarly extended at 81 while TD Combo’s setup is fully formed. This endorses the view that a pullback in MARA is imminent.
I wrote back to my friend and told him I would be joining him in buying MARA puts. To that end, I purchased a $27 put with a January 12 expiry for $4.25.
The Relative Strength Index (RSI) is a useful indicator for identifying oversold levels and bullish signals in the stock market. Using both has helped me to make informed decisions about when a bullish trend or bearish trend is ripe for reversal.
When the RSI dips below 30, it can signal an oversold condition and a potential buying opportunity, especially for long-term investors looking to enter at favorable prices. However, the time period matters—more conservative traders may want to see an RSI below 30 sustained over several days before acting, while more aggressive day traders may look to capitalize on short-term oscillations.
No single indicator should be used in isolation when analyzing the stock market. Using the RSI in conjunction with other technical analysis tools can validate signals and improve timing. For example, combining RSI with the Sequential and Combo indicators from Tom DeMark can spotlight exhausted trends poised for reversals.
Tuning into overbought/oversold seems the best choice to profit from countertrend bounces. However, traders must act quickly as the optimal entry points may only last briefly. With the right indicators and strategy, identifying overbought/oversold conditions can help provide you with high-probability and profitable trading opportunities, thus allowing for better investment decisions.
- Mark Fortune is a seasoned journalist and editor with more than two decades of experience. Specializing in technology, cryptocurrency, and stock investments, his incisive writing has made significant contributions to the business journalism field. Mark’s work is celebrated for its depth, clarity, and influence on a global readership.
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