The Trade for a Living Oscillator
Measuring Short-Term Overbought and Oversold

By: Duane Davis

When a market becomes very overbought or very undersold, it has a tendency to stall out.  A market that has been going up will eventually become overbought and traders that have been long will take their profits.  In order to take their profits, they must sell their positions and this extra selling will put pressure on the market.  If enough selling occurs, it often leads to a pull back.  Similarly, a declining market soon becomes over sold and traders that have been short will have to buy back their positions.  This extra buying often brings the decline to an end.

There are several ways to measure overbought and oversold conditions.  One of our favorites is with the simple formula below:

Highest price in the last 5 Days – Open 5 Days ago = X

Last Close – Lowest Price in the Last 5 Days = Y

(X+Y) X 100
(Highest Price in Last 5 Days – Lowest Price in Last 5 Days) X 2

Here’s an example:

Let’s calculate the Trade for a Living Oscillator for the September S&P 500 futures as of the close of the day session on July 8th 2003.

 

Open

High

Low

Close

July 1, 2003

968.50

982.30

960.50

981.20

July 2, 2003

983.00

993.80

982.20

992.90

July 3, 2003

986.20

994.20

976.00

982.50

July 7, 2003

992.50

1005.00

992.50

1002.50

July 8, 2003

1000.80

1008.50

997.50

1007.60

As we can see, the highest high for the 5-day period that ends on July 8th happens to be the high for July 8th at 1008.50.  The open price of the 5-day period was the open of July 1st at 968.50. 

1008.50 – 968.50 = X   (X = 40.00)

The last close of the 5-day period was the close of July 8th at 1007.60 and lowest price during the 5 days was the low of July 1st at 960.50.

1007.60 – 960.50 = Y  (Y = 47.10)

The last step in the formula becomes:


(40.00 + 47.10) X 100             =           87.10 X 100          =         8710      =          90.73

(1008.50 – 960.50) X 2                         48.00 X 2                           96

The oscillator value for the next trading day July 9th would have been 90.73.

Values in the Oscillator range from 0 to 100.  The higher the value, the more overbought the market is and the lower the value, the more oversold it is.  Therefore, before the market opened on July 9th, we knew that on a short-term basis, the S&P had become overbought.

In this example, we use a “look back period” of 5 days.  Look back period can be any number the was want to use, but for day trading, we prefer 5 days.