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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Inspired by his high school economics teacher, Rick Pendergraft fell in love with the markets at an early age. He entered his first investing competition at 17, and opened his first brokerage account before he finished college. At the age of 23, on the third options trade he had ever placed, Rick turned $1,800 into $22,000 in less than a week, when the company he bought became the target of a takeover. He admits it was a stroke of luck, but it was a memorable education as to the leverage that options can provide. After a ten year career in banking, Rick decided to pursue trading full-time. To get his foot in the door, he started out in the sales department at Schaeffer's Investment Research. It was not long before his talent was recognized and he was invited to apprentice under Bernie Schaeffer, one of the top options traders in the world. Rick thrived in his new position and twice received the award for "Top Trader."Rick has developed a loyal following of readers who are grateful for his timely warnings and profitable advice. He is widely recognized as a market expert and has been frequently quoted by Reuters, BusinessWeek, Forbes, USA Today, the New York Times, and the Washington Post. Rick's primary focus is on identifying short and intermediate term rising and falling trends in the major market sectors. His analysis is based on technical factors along with indicators of market sentimentRick lives near Delray Beach, FL with his wife and three children.