What Happens When Stock Markets Are Overbought? Historical Analysis
When stock markets are overbought, we can expect weaker returns than average over the next few days. But in the long term, returns gravitate toward the average returns. Thus, overbought stock markets only predict short-term results – not long-term.
In this his article we try to answer what happens when stock markets are overbought with backtested rules.
We backtest the following trading rules:
* We buy at the close when the 2-day RSI is above 95.
* We sell at the close after N days.
This is a simple strategy, but we make it simple to prove our point. The Relative Strength Indicator (RSI)is used because it goes from oversold to overbought conditions constantly and it measures the velocity of those moves. When values are high, it indicates a euphoric market as it has risen a lot over the defined lookback period.
We sell after N days to show how the edge disappears after some time. We use the optimization function in Amibroker to produce the table shown below.
If we flip the strategy, the results are much better. Check here>>
https://www.quantifiedstrategies.com/what-happens-when-stock-markets-are-overbought/
