Commander in Pips: During previous chapters I’ve said that this or that indicator has some lack in estimating Oversold/Overbought conditions on the market. But today we will discuss a couple of indicators that are perfect for that purpose. I’ve decided to take a look at couple of them, because not all software has them both. So, you will not be frustrated, because at least one of them usually exists. These indicators are very simple. They are – Detrended Oscillator (DOSC), aka just Oscillator, and Momentum. Personally, I use DOSC for estimation of oversold and overbought condition on the market. Also it has some additional ways That it could be used. Metatrader 4 comes with Momentum as one of its built in indicators.
Pipruit: Cool! Finally, because I even thought that I will never find the perfect indicator for oversold/overbought recognition.
Commander in Pips: In the beginning I want to say, that my preferred indicator is DOSC. So, I will talk particularly about it. But, if it turns that your software does not have it – use Momentum. All that I will say about DOSC is absolutely applicable to the Momentum Indicator as well.
So, both DOSC as well as Momentum consist of just a single line. It’s simple. Their math is very simple:
DOSC=Close Price – Some MA (N);
Momentum = Close Price – Close Price N days ago
So, as you can see, there is only one difference – DOSC uses average value of close prices for some period, and momentum pure close price some days ago. Personally, I use for DOSC N=7 and simple MA for averaging, so my formula of DOSC:
DOSC = Close Price – SMA (7);
Pipruit: Commander and why are you so fascinated with them? They are quite simple…
Commander in Pips: Indeed! And this is excellent, that they are perfect. But the major advantage of these indicators is that they are not scaled in the range! So they much better show overbought and oversold during really solid thrusts. I’ll show you:
Chart #1 | EUR/USD weekly DOSC(7); Momentum (7); Stochastic (8; 3; 3On chart #1 you see obvious comparison scaled Stochastic with non-scaled DOSC (blue line) and Momentum (black line). You should remember this chart – we’ve used it much in current chapter. So, take a look at strong down trend in the beginning 2010. When the market accelerates to the downside in April – both DOSC and Momentum establish new lows and a stronger level of oversold. And now look at what Stochastic has shown – It even has risen! The same is happening now. Take a look – both DOSC and Momentum show that the market is not in overbought condition, but Stochastic is above 75! We can replace Stochastic with any scaled indicator and we will get the same result. I hope that these examples should be enough and the conclusion is obvious – scaled indicators skew the real level of overbought and oversold conditions.
Pipruit: But Commander, how we will use DOSC or Momentum, since they are not scaled? How we will estimate when the market is oversold or overbought?
Commander in Pips: This is an excellent question son. But the answer is simple – we will use their historical extreme values:
1. We have to estimate the extreme high (or average of 2-3 highest highs) and the extreme low (or average of 2-3 lowest lows);
2. When DOSC or Momentum will reach an extreme high – then the market is overbought. When it will reach an extreme low – then the market is oversold;
3. You may not use 100% of these extreme high or low of DOSC. You may apply, for instance 80-90% of these levels to make a conclusion that market is overbought or oversold. For instance, if historical DOSC extreme high is 850 points – you may use 90%*850 = 765 points level as overbought. The same is for oversold – if extreme low is, say, “-650” – you may use 90%*(-650) ~ -585 points as oversold;
4. These critical DOSC levels have a tendency to change when market renews DOSC high or low. So when it will happen – you will have to recalculate your extreme levels. This is another great advantage of non-scaled indicators – they are always tracking current market volatility and allow you assess it more clearly.
5. These levels will be different for different time frames and pairs. So, the weekly period has its own oversold/overbought in difference to monthly and daily time frames. You have to calculate them for each time frame that you trade at.
Pipruit: And how far back in history should I apply to estimate extremes?
Commander in Pips: Well, I suppose – not less than 130-150 trading periods (candles). If you will take too much, then it could lead to skewing of real level of overbought and oversold. Because volatility could change in recent times, and applying too far historical volatility data that was much lower/higher could lead to wrong levels for targeting overbought/oversold levels.
Pipruit: Could you give me an example?
Commander in Pips: Sure, let’s take a look at this EUR/USD weekly chart # 2. We have to use a historical chart, just to see then – how estimated levels have worked in future. According to our algorithm we have to estimate extreme levels for DOSC. I prefer to use not just single value but average of 2-3 extremes. So, I’ve pointed by red ellipses the extreme highs for that historical period and the extreme lows, that we will use for calculation of levels overbought and oversold:
1. Overbought = (532.86 (10.05.1998) + 553(02.01.2001) + 559(05.19.2003))/3 = 548.28 ~548 points
2. Oversold = (-386.71 (03.01.1999) - 442(05.01.2000) – 365(08.18.2003))/3 = -397.90 ~ -398 points
3. We will use 90% from both of them. Hence our overbought = 548*90% = 493 points and oversold = -398*90% = -358 points.
So, let’s mark this level on the chart. When market will approach to these areas – we will suggest that it overbought or oversold.
Chart #2 | EUR/USD weekly DOSC(7)And now we will check how it works – the green vertical line shows where our future has begun.
Chart #3 | EUR/USD weekly DOSC(7)
Results you can evaluate by yourself…
Pipruit: This is tremendous results, especially if we take into consideration really strong upward trend. Every time, when DOSC shows overbought level – when it reaches the upper border at 493 points, the market shows some pause in move or retracement, till DOSC corrects lower. The same is true for oversold. DOSC catches every peak in uptrend! This is really outstanding.
Commander in Pips: I’m glad that you like it.
Pipruit: And how we can apply it? Sell at overbought and buy at oversold?
Commander in Pips: Not quite. DOSC is a fine tuning tool and demands more delicate uses. You can’t just buy or sell due DOSC because it doesn’t show trend! This will be a mistake if you’ll do this. You should use it as additional tool in your overall trading context. Here is how it could be done.
1. When DOSC reaches 75-100% of oversold/overbought level, i.e. its extremes – close position. Let’s suppose that you hold Long position. After some time market shows significant thrust up and DOSC hits 90% from it extreme high. It’s time to take profit;
2. Level of oversold/overbought should be estimated on daily or higher time frames. This is just safer. You can apply DOSC on intraday charts also, but there is has a tendency to change extremes much more often;
3. If, for instance you trade on intraday charts, and daily DOSC is close to extreme - then you should apply the nearest intraday profit targets. It could be intraday 0.618 Fib extensions or previous highs – they hardly will be taken out due to daily overbought condition. The same is true for oversold.
4. If market reached Oversold or Overbought and does not bounce – stays with it or continues to creep higher/lower, then it tells us that the market is very strong in that direction and this move should continue. Forex is financial market and financials very rare stand at overbought/oversold levels for a long time.
5. Higher time frames overrule lower time frames. Assume that market is oversold on weekly time frame. In this case it could lead to significant break of daily overbought level, so daily DOSC could establish new highs during an upside retracement on the weekly time frame.
Filter entry points
You should not enter long when DOSC is near extreme high and shows that the market is overbought. As well as you should not enter short when DOSC is near an extreme low and shows that the market is oversold.
Check it here – assume that you use 25-period SMA for trend identification. When price is above the MA – the trend is bullish and you search for the possibility to enter long, when price is below the MA – the trend is bearish, and you want to go short. But what’s a pity – where to enter?
DOSC allows you to filter unwelcome entry points. Check chart #4 – every time, when trend holds but DOSC at an extreme – the market shows solid retracement, that you do not want to enter. But when DOSC is not at extreme – entry points are much safer.
Chart #4 | EUR/USD weekly DOSC(7) and SMA(25) – filtering entry pointsI’ve pointed not all points – just some of them, to show how you could apply DOSC (or Momentum) in this way.
You can use extreme values for estimation the levels for stop placement. For instance if you intend to enter Long and DOSC shows that market is 70% oversold. You may place stop beyond 100% oversold. But control your risk, because depending on volatility this stop could be really far away. I better call this stop as “for catastrophe”. Also, if you trade intraday – you may choose daily levels of overbought/oversold to place stops beyond them. Understand, this stop will not be triggered too often. Only if the market will break its level of overbought/oversold. But if it will happen – it means that situation on the market has changed drastically and your position has turned to the wrong one anyway.
Another way to apply DOSC in this way is to build it not on close prices but on high prices or low prices. If, for instance, you intend to enter Short and market is overbought, then you can draw DOSC, based on high prices = High – SMA (7) by highs. It will be slightly higher than DOSC based on close prices. If you will place stop above this level – it will be very logical, because market will not trigger it occasionally, only if really something bad happens. The same is for DOSC based on Low prices.
Combination of Overbought/oversold and Support/resistance levels
This strategy is relatively simple. Joe DiNapoli calls it “Stretch”.
1. If the market reaches overbought based on DOSC value right at some resistance (simple line or Fibonacci level) – then there is high probability, that the market will bounce down from this area or at least turn to sideways, despite the trend direction, that could be strongly upward.
2. If the market reaches oversold based on DOSC value right at some support (simple line or Fibonacci level) – then there is high probability, that the market will bounce upward from this area or at least turn to sideways, despite the trend direction that could be strongly downward.
3. It counts that this combination is still in play, until DOSC will not reach zero level. So, if you have taken this signal and entered, say, short from (overbought + Fib resistance) combination – you will have to close position when DOSC will reach the zero level, despite at current profit or loss on your position. Because the market can stand in the range but DOSC moves to zero anyway. In this combination you will probably get some loss.
Check this chart and all will become clear:
Chart #5 | EUR/USD weekly DOSC(7) and SMA(25)Look – trend is bullish, because market is strongly above 25-period SMA. But here you suddenly see that market has hit 0.618 Fib resistance and DOSC hit at the same time high extreme. So market is overbought at a Fib resistance level! You’ve entered short. When DOSC decrease to zero - you’ve exited from short trade – trend is still bullish! So you have no reason to hold short position any longer.
By the way – this is weekly chart, so 300 pips for couple of weeks, not bad ha?
4. Since this kind of trade is always in opposite direction to the major trend – you should exit quickly. In fact, we may call it a “scalp” trade compared to the time frame. In other words – this trade is just an attempt to play on retracement under some predefined circumstances - a combination of DOSC extreme and some support/resistance level at the same time. If something goes wrong – exit immediately – because your position here is against the major trend!
5. This signal works better if there is a combination of 0.618 level rather than 0.382 Fib level
Volatility Breakout (VOB)
This strategy is better applied for long-term charts (monthly, weekly). If DOSC for a long time shows and holds some level of overbought/oversold and then suddenly breaks it by estimating new extreme levels (preferably if DOSC doubles its previous extremes), then we should wait for a 0.618 retracement after the DOSC breakout and enter in the direction of the breakout. The reason is that Volatility change of pace is usually faster than price, so a Volatility extreme appears earlier than price one. As a target you may use the new extreme DOSC level, some Fib extensions or others.
Pipruit: Thanks, Commander. This is outstanding material.
Commander in Pips: You’re welcome. I hope it helps.
Pipruit: I see. And why are you so fascinated with DMA?