When Stock Markets Are Overbought: Understanding Historical Trends
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.
This post tries to answer what happens when stock markets are overbought. Overbought means that markets have risen over a certain period and this might indicate weaker returns ahead. The media might throw more fuel into the mix by writing positive articles and thus create FOMO (fear of missing out). Opposite, when there is “blood in the streets,” the media writes about how bad it is and creates panic.
Our backtest has the following rules:
We buy at the close when the 2-day RSI is above 95.
We sell at the close after N days.
We sell after N days to show how the edge disappears after some time. We use the optimization function in Amibroker to produce this table shown below.
You can find more info about this trading strategy here:
https://www.quantifiedstrategies.com/what-happens-when-stock-markets-are-overbought/