PDSnet Online Investment Course

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Please change all images to the following format: <figure class="figure"><img src="..." class="figure-img img-fluid"><figcaption class="figure-caption">A caption...</figcaption></figure> (images in current articles are already changed)

The subject of technical analysis (or “charting” as it is sometimes called) began in the Western world with Charles Dow in the late 19th century (see module 15). He observed that Wall Street, measured by the index which still carries his name, tended to move in distinct patterns. He noted three types of moves – bull trends and bear trends, secondary trends and what he called daily fluctuations (but which could last a few weeks).
Starting from this base, technical analysts have developed innumerable indicators which are designed to help predict the future movements of share and other security prices. The idea is that investors, as a group, have behavioural characteristics which manifest themselves in charting patterns and so make them to some extent predictable.
Beginning with the simple moving average (explained in module 23) we have examined various complications and variations of line indicators. In this module we will consider the Overbought/Oversold or OB/OS indicator and try to link it back to the group investor behavioural patterns that it exploits. You may find some of the ideas in this module hard to understand at first. Just go back and re-read it and listen to the webinar which follows it.
The OB/OS arose from the study of moving averages. Technical analysts saw that the best signals were actually given, not where the share price cut up or down through its moving average, but rather where the gap between the moving average and the price was at its greatest. Consider the following chart:
 
<figure class="figure"><img class="figure-img img-fluid" src="/onlinecourse/img/mod26_chart1.png" alt="" />
<figcaption class="figure-caption">Price Chart with Moving Average No. 1 Chart by ShareFriend Pro</figcaption>
</figure>
 
Here you can see a price chart with a typical moving average superimposed. It is easy to pick out the “buy” and “sell” signals (shown by the red circles). But what technical analysts noticed was that, it was far better to buy or sell where the gap between the moving average and the price was at its greatest – as follows:
 
<figure class="figure"><img class="figure-img img-fluid" src="http://www.pdsnet.co.za/onlinecourse/img/mod26_chart2.png" alt="" />
<figcaption class="figure-caption">Overbought/Oversold Chart 2. Chart by ShareFriend Pro</figcaption>
</figure>
 
The vertical red arrows show the points on the chart where the gap between the price and the moving average is the largest – and that is where the price is at its highest or lowest – giving the best “sell” and “buy” points.
From this observation the OB/OS was developed. In simple terms, the OB/OS measures the gap between the price and its moving average and expresses it as a percentage of the moving average at the same point. If we call the gap between the price and its moving average “A” and the moving average itself “B” then the formula for the OB/OS is:
 
OB/OS = (Price – Moving Average)/Moving Average X 100
 
Look at the chart again with this in mind:
<figure class="figure"><img class="figure-img img-fluid" src="http://www.pdsnet.co.za/onlinecourse/img/mod26_chart3.png" alt="" />
<figcaption class="figure-caption">Overbought/Oversold Chart 3. Chart by ShareFriend Pro</figcaption>
</figure>
 
You can see that we have called the gap between the price and its moving average “A” (given by subtracting the moving average from the price) and the moving average itself, “B”.
Now consider that as the line “A” approaches the moving average sell signal it becomes shorter and shorter and shorter (shown by the red lines getting shorter and shorter), until at the sell signal it is zero. This must be true since the sell signal occurs where the price and the moving average are at the same level – so price minus moving average must be zero.
After the moving average sell signal (i.e. to the right of it), the moving average is higher than the price and so price minus moving average will be negative. So the OB/OS moves from being positive to being negative and then back to being positive again as the price crosses and re-crosses its moving average – as shown below:
 
<figure class="figure"><img class="figure-img img-fluid" src="http://www.pdsnet.co.za/onlinecourse/img/mod26_chart4.png" alt="" />
<figcaption class="figure-caption">Overbought/Oversold Chart 4. Chart by ShareFriend Pro</figcaption>
</figure>
 
So in the chart, the OB/OS oscillates from being negative (-VE) to zero (at the first buy signal) to positive (+VE), back to zero (at the sell signal) to negative (-VE), to zero and back to positive (+VE).
It is now possible to draw the OB/OS separately from the price chart as an oscillator, oscillating from negative to positive and back again. Consider the following diagram:
<figure class="figure"><img class="figure-img img-fluid" src="http://www.pdsnet.co.za/onlinecourse/img/mod26_chart5.png" alt="" />
<figcaption class="figure-caption">Oscillator Diagram 1</figcaption>
</figure>
 
You can see that the OB/OS oscillates above and below zero. Note that the Y-axis shows the percentage, either positive or negative.
Where the OB/OS is at zero, that is where there was a moving average buy or sell signal. Another way of thinking about this chart is to think about pulling the price line tight – into a straight line with the moving average oscillating above and below it.
We have said that technical analysts observed that the best place to buy was when the price was furthest below its moving average and that the best place to sell was where it was furthest above – but how does this OB/OS help us to see where it reaches those extremes? It just looks as though we have manipulated the numbers into a different form, but the problem remains unsolved. What have we achieved?
What we have achieved is that we have reduced our problem to an oscillator – which means that we can now apply the concepts of statistics and probability. Don’t be put off by those big words. What that means is that we can go back over the past thirty years on the OB/OS of a share that we are interested in and see that it has never been wrong to buy it when it fell below 15%.
We can in fact establish a “buy line” at the minus 15% level – as shown by the horizontal dashed line on the diagram above.
As you can see, the OB/OS crosses this “buy line” when it breaks down through it and then again when it breaks up – but the share’s price will be lower when it breaks up through the buy line – and that is your buy signal. The point is that while the OB/OS is below the buy line, the share price must be falling – and it is only when it begins to recover and breaks up that we can become interested in buying it.
Now you might say, “Well, why don’t we just put on a +15% sell line and then we have this share market thing wrapped up” – but it’s not that simple.
Beginners tend to think that buying and selling are just like the two sides of a coin – the same thing just the other way around. But professional investors know that there is a great difference between buying and selling, because when you are buying you can optimise in two dimensions – in terms of which share to buy and in terms of when you choose to buy it – but when you are selling you can only sell the shares that you have. You cannot choose which share to sell.
Whereas you could look through the entire market for shares below your -15% buy line in order to buy them, there is no point in looking through the entire market for shares which are above a +15% sell line – because the high probability is that you don’t have them to sell!
So when you are selling you can optimize in the time dimension. For that reason, the OB/OS is primarily a buying technique. It is designed to get you into the market at the right price. And that is important because in the share market you make your money when you buy – not when you sell. If you buy at the wrong price you’re dead!
Now let’s return to that OB/OS diagram:
 
<figure class="figure"><img class="figure-img img-fluid" src="http://www.pdsnet.co.za/onlinecourse/img/mod26_chart6.png" />
<figcaption class="figure-caption">Oscillator Diagram 2</figcaption>
</figure>
 
We have marked the OB/OS buy signals with circles.
Even though the OB/OS is mainly for buying, there are some things you could do to get sell signals. Typically, at the top of a trend there is a period of sideways movement – which reflects the uncertainty in the market when the smartest and the most stupid money are both in the market at the same time with diametrically opposed views of what is happening. The wide divergence in their opinions about what is going to happen next causes the market to jump around in a narrow range (i.e., move sideways) while it finds new direction.
You need to recognise this sideways movement for what it is - and sell out. Do not be afraid – the OB/OS is an oscillator – it must return to -15% and you will have another opportunity to buy – if not this share then another.
But what are we actually measuring with this OB/OS? We are measuring the rapid departure of the price away from its moving average. After all, if the price does not accelerate quickly away from its moving average rapidly, then the price will move down with the moving average – and there will be no significant gap between the two (which, remember, is what we are looking for). So, what do you think would make a share’s price move quickly away from its moving average? What human behavioural characteristic?
Panic – maybe, but the word we are looking for here is the word “over-reaction”. Human beings are always over-reacting to things. To over-react is a quintessentially human characteristic and it is always visible in the markets. The OB/OS gives you a method for quantifying those over-reactions. For example, you can look back over 30 years of OB/OS on a share and determine that it has the propensity to over-react to about the -15% level. This is an immensely powerful understanding.
You could for example, establish that, over the past 30 years, your share has spent just 2% of its time below the -15% buy line. I put it to you that, if that is the case, then your statistical probability of being wrong in buying it at that level is extremely low. And you have one great satisfaction – you are not buying it at +15%. But somebody did. Otherwise, the chart would not go there! And you must be doing better than that person - not so?
 
<h2>Examples in the Market</h2>
 
<h3>JSE MINING INDEX</h3>
 
Consider the following OB/OS chart of the JSE Mining index over the past 13 years against a 200-day moving average:
 
<figure class="figure"><img class="figure-img img-fluid" src="http://www.pdsnet.co.za/onlinecourse/images/JSE-MINI.png" />
<figcaption class="figure-caption">JSE Mining Index OB/OS from January 2008 to April 2021 - Chart by ShareFriend Pro</figcaption>
</figure>
 
You can see here that the JSE Mining index, which is an average of the prices of mining shares on the JSE, has been very volatile over this period – which is what you expect from a commodity-based index. The 200-day OB/OS has oscillated above and below the horizontal blue zero line. During that 13-year period there were definite points at which it would have been very profitable to buy into mining shares. Those are the points at which the index was more than 32% oversold. The horizontal red line is a buy line set at -32%. This level has been breached just three times  over the 13 years and on each occasion, it drew attention to a very good buying point.
The one criticism which has been leveled at the OB/OS is that it often gives the buy signal too early – and you will see that in the chart above. For example, the most recent buy signal came in December 2016, whereas probably the best buy point occurred in March 2017. Nonetheless, if you had bought at the buy signal you would by now be well “in-the-money”. What is clear, however, is that the OB/OS would certainly have drawn your attention to the fact that gold shares were relatively cheap and that a buying opportunity was imminent.
Conversely, there are three points on the OB/OS chart above, where the OB/OS went to absurdly high levels – well above +70%. You can now see that, statistically, your probability of being right in buying at such a point is very, very low – and yet, somebody did buy there, because otherwise the chart would not go there!
So the OB/OS is useful because it significantly improves your probability of being right. It prevents you from getting into the market when it is at historically crazy overbought levels and alerts you to the fact that a share or index is at a very oversold point in the context of its history.
 
<h3>S&P500 INDEX</h3>
 
Let us consider another example – the S&P500 index – which is a weighted average of the 500 largest companies trading on Wall Street:
<figure class="figure"><img class="figure-img img-fluid" src="/onlinecourse/images/OBOS_dj_500.jpg" />
<figcaption class="figure-caption">S&P500 Index 1988 to January 2021 - Chart by ShareFriend Pro</figcaption>
</figure>
 
Here you can see the S&P over the past 32 years (the top chart). Underneath it is a 200-day OB/OS. I have highlighted the three major lows with red circles when the OB/OS went below the buy line at -25%. The first occurred a year after the 9/11 bombing of the World Trade Centre in 2001. The second came in 2008/2009 as a result of the sub-prime crisis and the liquidation of Lehman Bros. The third came during the COVID-19 pandemic in March 2020.
The second buy signal marked the start of the great bull market which, in our view, still persists today.
The OB/OS would have drawn your attention to the fact that at each of these major selloffs, shares were trading at very cheap levels and hence represented a potential buying opportunity.
The above chart is based on a 200-day simple moving average (i.e., it shows the gap between that MA and the index drawn as an oscillator). Longer moving averages give less frequent oversold signals while shorter moving averages would result in more signals.
In addition, the deeper you make your buy line the less signals you will get, but the more reliable those signals become. This implies that you need to look at the OB/OS for the shares and indexes that interest you and decide exactly where the best position for your buy line is in each case.