Oversold and overbought are two technical analysis words that I’d like to ban! The phrases seem to suggest that a stock, currency or futures contract really should not decline, or advance, anymore. In an overextend wave, however, we should not attempt to expect anything rational from the highly emotional driven price trend. Wave extensions are a bit like an avalanche, or tidal wave. They are a huge mass that has gained enough speed and momentum to break through anything. Do you consider an avalanche to be prone to a reversal? Hardly. We know that there is a point where they will stop, but we don’t want to get in the way as they are approaching. Let’s talk about the danger of incorrectly timing an “oversold” market.
Do you consider an avalanche to be prone to a reversal?
The genesis of this article came as a result of the last several months of commentators calling the EURUSD “oversold.” I’ve written about this once before (here). When you see such an extreme acceleration to the downside, what’s the best approach from a trading perspective? The Wolf used the word “climactic,” and maybe you have heard the term “capitulation.” What do they mean, and where are we, in an Elliott cycle when we see a selling climax or capitulation like the one in the EURUSD?
A bear capitulation happens when bears and bulls share the same opinion about lower prices. Yes, there are smart bulls in the EURUSD trend, but they had absolutely no reason to buy when they are convinced that lower prices would come. Those who are stuck with their existing long position are panicking, because smart sellers are totally laid back in their already large, winning trend following positions, while smart buyers are waiting for better bargains (i.e. cheaper prices to buy). The market is one sided, and when someone would like to sell a EURUSD long it can only happen at lower prices. That forces others to seek an escape, and the whole spiraling effect escalates in a series of unusually large bear trend bars and an apparently parabolic decline.
It is true that the decline is not sustainable, and it reaches the minimum point swiftly in a couple of bars. But have a look at the EURUSD chart. What timeframe represents this climax the best? The largest Context timeframe I typically use is the weekly, but the climax is also apparent on the monthly, and can you imagine being just a “couple of bars” early at this speed? Considering the weekly 3000-4000 pip decline it would be a costly “miss” for sure. So, how does one improve the timing?
Think of the coming reversal (when it comes) as either a change in trend, or the start of the largest and the most volatile correction since the beginning of the trend. Probability: 15% change in trend, 75% largest correction, 10% other. Here are the three most probable points in the Elliott wave cycle that can represent the current situation:
- Point of recognition – midpoint area of third of third (see the grey 1 below).
- Parabolic capitulation at the end of a third wave – should be followed by a sharp start and a volatile fourth wave correction (check grey 2).
- End of a fifth wave extension panic (grey 3).
It is much better if I show it visual on three schematic diagrams:
Our RSI study comes in really handy in detecting overextended trends. The RSI either penetrates above our green “sustainable bull trend area” or under the grey “sustainable bear trend area” like it does above in the EURUSD. I like to describe a phase like this as a “strong bear trend with unreasonable risks for initiating new short positions.” Because of this, I can only exploit the accelerated phase on smaller time frames. The weekly timeframe is useless, besides the identification of the climax. This weekly chart, with the extreme level 15 RSI reading is below our grey area, and is actually “oversold,” if you wish, but it does not mean there’s a bull setup at all. I would not attempt a buy when it returns above 30 as many popular technical analysis method suggests. Just look what happened after December 14 when the RSI reached 33.1!
These capitulations are followed by sharp reversals, often without any warning deceleration, making bottom fishing so enticing. Everybody is excited about the V-shape reversal possibility, and the quickie in terms of money making on the buy side. That will happen 10-15% of the time, but watch out the other 85-90%. If you are early just one bar (here one week) the trade idea is toast, because by the time of the reversal, you already had to finance a substantial loss. Keep in mind that the reversal would need to yield 6-7 times more just to breakeven, when trading against a climactic trend. Not a robust, mathematically solid approach.
Rather than fight against the larger context, might we suggest looking at other instruments with better Context and Momentum profiles, which leads to a higher probability situation. Or of course exploit the EURUSD volatility on lower time frames as day trade opportunities are plenty. Either way be aware of the timing problem of these exhaustion patterns.
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.