How Elastic Are Your Trade Indicators?

Thank goodness it is 2009! The fourth quarter of 2008 was crazy for the market. The wild swings and incredible volatility were maddening. Most investors don’t want to be reminded of how bad it was, but it was apparent in their monthly statements. The good news is that it is over.

But there is a lesson to be learned from every rough patch. One of the lessons I learned from the crazy market of fourth-quarter 2008 has to do with the elasticity of indicators.

Here’s what I mean by “elasticity.” A number of indicators – including most of the overbought/oversold indicators – are calculated based on the most recent trading activity. In the fourth quarter, these indicators were stretched out like an elastic waistband, thanks to big moves in both directions.

The Relative Strength Index, for example, uses volume and price change in its calculations. When a stock goes up 4 or 5 percent two days in a row – and then drops 4 or 5 percent the next day – the RSI is getting stretched out. When the market calms down and that same stock is moving less than 1 percent per day, the overbought and oversold levels are harder to reach because the RSI is stretched out from the 4 and 5 percent moves. As a result, you get fewer trading signals from this indicator.

With the market settling down a little, the overbought/oversold indicators are starting to look normal again.

If you use these indicators in making your trading decisions, they probably lost some of their usefulness in the fourth quarter. Now that they are moving back to a more normal state, they should become more useful.

I personally cut back on my trading because I wasn’t getting enough signals from the indicators I use. Now that the calendar has rolled over to January, I am starting to see more opportunities.

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