What Happens When Stock Markets Are Overbought?

Last Updated on June 19, 2022 by Quantified Trading

When stock markets are overbought, we can expect weaker returns than average over the next few days. But in the long term, returns gravitate toward the average returns. Thus, overbought stock markets only predict short-term results – not long-term.

This article tries to answer what happens when stock markets are overbought. Overbought means that markets have risen over a certain period and this might indicate weaker returns ahead. The media might throw more fuel into the mix by writing positive articles and thus create FOMO (fear of missing out). Opposite, when there is “blood in the streets,” the media writes about how bad it is and creates panic.

What is mean-reversion:

First, let us describe what mean-reversion is. Mean reversion is another description of the statistical term called regression to the mean. Both terms simply mean that strong deviations from the trend are most likely situations that later turn around and go in the opposite direction. As our backtest below indicates, you can at least expect weaker results in the coming days after reaching an overbought condition. By weaker, we mean both compared to the earlier period and the long-term average returns.

However, all rules have exceptions. We are only using statistics and general conclusions – the law of large numbers.

What does overbought mean?

Overbought means that the stock market has risen over a certain defined period of days, weeks, or months. You can, of course, define the period yourself.

If you use a daily time frame in trading of fifteen days, you need to define how much it should rise during this period to label it as overbought.

We prefer to use numbers to illustrate our arguments. Let’s formulate a trading strategy to define overbought. We use an oscillating indicator for that purpose:

What happens when stock markets are overbought?

We show what happens when stock markets are overbought like we always do: we backtest!

Our backtest has the following rules:

  1. We buy at the close when the 2-day RSI is above 95.
  2. We sell at the close after N days.

This is a simple strategy, but we make it simple to prove our point. The Relative Strength Indicator (RSI)is used because it goes from oversold to overbought conditions constantly and it measures the velocity of those moves. When values are high, it indicates a euphoric market as it has risen a lot over the defined lookback period.

We sell after N days to show how the edge disappears after some time. We use the optimization function in Amibroker to produce this table:

The first column shows when we exit: row one is after 1 day, row after 2 days, etc.

The table shows that the returns in the first five days after entry are significantly lower than the long-term average, which is about 0.05% per day, please see our article about night trading to study this more. However, as time goes on, the returns gravitate toward the long-term averages – as expected.

The backtest also illustrates why short-selling is difficult: even though the results show negative returns over the first days after reaching an overbought condition, it’s not a tradeable trading strategy. If we flip the strategy, the results are much better:

Please read what happens when stock markets are oversold for more on this.

What happens when stock markets are overbought? Conclusion

The backtest in this article shows exactly what happens when stock markets are overbought: we can expect lower returns than the averages in the short term.

 

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