Market psychology tends to roll in waves… a wave of euphoria followed by a wave of pessimism, overconfidence followed by fear. As a result, markets advance (or decline) in a volatile manner as they bounce between “overbought” and “oversold” levels. Both investors and traders are easily swept along in these buying panics or selling panics, only to find themselves jumping in near a short-term peak or selling right at a short-term bottom.
An “overbought” market condition can be defined as stock prices having climbed too far, too fast, with too much volume flowing into too few stocks. In simple terms, the more overbought a market becomes, the higher the probability that it will level off to digest its recent rise, or even correct downward – giving back a portion of its gain. The opposite is true for an oversold market.
Our Pressure Factor was developed to measure the degree to which the market is overbought or oversold in the short term. Readings below -30 are defined as being moderately oversold and readings above +30 are defined as being moderately overbought. Moderate readings typically carry very near-term consequences and are useful for making tactical trades.
Extreme readings, which typically precede more meaningful moves in the market, are defined as being -60 or below for oversold readings and +60 or above for overbought readings. The Pressure Factor reaches these extreme levels relatively infrequently, and they tend to carry more significant consequences than moderate oversold/overbought readings. For example, the Pressure Factor surged to +115 in the rebound following the 2020 COVID Crash, which was the most overbought reading in over 30 years. The next three days saw the S&P 500 lose -7.2%, including a single-day loss of -5.9%!
Since markets can often reach an extreme overbought/oversold level, the Pressure Factor should be used as a trigger when it exits these regions. In other words… the time to purchase stocks is not when the Pressure Factor enters the oversold region, but rather after it bottoms and exits the oversold region. Conversely, the time to sell a stock is when the Pressure Factor exits the overbought region.