This indicator designed to play market oversold condition at the index level is related to the Bollinger Band theory. For those who don't know, Bollinger Bands are one of the most useful statistical tools used by technical analysts (Mr. Bollinger even registered the commercial name!). The Bollinger Band is an envelope around the price average that, in its standard form, encompasses all values that are within 2 standard deviations.
If you don't remember what standard deviation is or hated your stats class, it's okay. We're not going to do the math here. But to put it simply, standard deviation is a measure of how spread out a set of data is. Specifically, it measures the average distance of each data point from the mean (or average) value of the data set.
Let's say you have a dataset of 5 people's ages: 20, 22, 24, 26, and 28. The mean age is 24, and the standard deviation is 2.24.
This means that, on average, each person's age is about 2.24 years away from the mean age of 24. In other words, the ages are fairly tightly clustered around the mean, with most people falling within a couple of years of 24.
If we assume that the ages in our dataset are normally distributed (which is a common assumption for many types of data), we can use the "68-95-99.7 rule" to estimate how many people fall within one, two, or three standard deviations of the mean. According to this rule:
Approximately 68% of the data falls within one standard deviation of the mean.
Approximately 95% of the data falls within two standard deviations of the mean.
Approximately 99.7% of the data falls within three standard deviations of the mean.
Going back to stock indices prices, a price outside the Bollinger Band is considered statistically oversold or overbought by technical analysts. However, it's important to note that just because a price is overbought or oversold, it doesn't mean we will see an instant reversal. As seen in the image above of the Tesla stock, the price can stay at the upper Bollinger band for a long period or go down for many candles on the lower Bollinger band. Nevertheless, it's worth noting that the standard Bollinger Band uses 2 standard deviations, which captures about 95% of the population. However, if we extend the deviation to 3 standard deviations (99.7%) or even more, such moves are usually considered outliers and on indices (which I will come back to later), they almost always trigger at least a technical rebound. What we have found is that whenever we see a breach of 2.5 to 3 standard deviations, we almost always see a considerable bounce back within the 2-6 day interval.
WU SP500 BandBreaker
The indicator shows ribbons made up of three different zones. The first zone is the 2.5 to 3 standard deviation (STD), the second zone is the 3 to 3.5 STD, and the last one is the 3.5 to 5 STD. It's possible to set up alerts on each of these lines in case of a breach that meets certain rules. These rules are: the opening price of the candle must not be too far from the 2.5 standard deviation price line. If it's far and it breaches, it usually means it's just the beginning of a free fall and we are not ready for a rebound. The slope of the 2.5 STD curve must be trending down. When this line is flat, a small move down can easily breach it, and this usually means it's just the beginning of a leg down and we are not ready for a technical rebound. The variation of that slope must not be too aggressive. This would also mean we are just starting a brutal move down and are not ready for a technical rebound. Here is an image of the indicator. The blue box/arrow shows the entry points that meet these criteria.
The graph above is on QQQ, but it has a great success rate on almost any indices. Its success rate is just higher on QQQ, and the 3X leveraged play on QQQ usually has a higher bounce back than a 3X leveraged play on the SP500, like UPRO. We put SP500 in the name since it will be part of the SP500 package, but it’s up to you to decide to use it on whatever you want.
Our personal strategy with this tool is:
1. whenever we see a breach of the 2.5 standard deviation on the Nasdaq Indices that meet my other criteria I buy a leveraged position on QQQ using TQQQ.
2. The next day I put a sell order at the highest price we have seen between the open and close of the previous candle (the one I bought). Most of the time my order is filled during that day and I am done with this trade. This target price is shown by the red line.
3. If my trade is still open In the upcoming days and If I see a price that is halfway between the price I bought and my target price, I usually put a stop loss there.
Has an example, on February 24th 2022 when the stock market opened on the Russian invasion of Ukraine, I bought TQQQ at around 41$. At close, the highest price between the open and the closing price was the close at 49.53$, so I filled up a sell order at that price. The next day when the stock market opened, my order was filled exactly at the opening price of 50.07$ for a gain of 22% in a day. Sometime it can take more than one day before I see my target price like for the January 24th 2022 signal and the return is also often less than 22%.
That is just one strategy that we made for ourselves. This one is very conservative but almost never fails. The essential point to remember here is that the indicator flags outstanding oversold conditions that usually trigger technical rebounds (at the index level). However, it's really up to you to decide how you want to play this signal. Some may want to have a more aggressive price target with tighter stop loss, while others may want to only play moves over 3 STD for lower risk and more reward (but with fewer occurrences) or that may just not be your type of trades.
On my end, I'm not really a trader. Most of the stocks I own haven't changed much since 2021, so hedging my position is something very important to me. Since a hedge signal usually needs to see some downward candles before triggering (although not always true since our hedge signal can provide signals without more than one candle down in some cases outside of a bear market), I see these rebounds as a relatively safe opportunity to recover that small loss and really meet my goal of never going down in our account. Also when we discovered that these move almost never fail, it was hard to pass on this opportunity !
Just to conclude on some remarks:
1. It’s important to understand that this signal do not mean that the move down is over and I think the example of the February 24th 2022 clearly show it, it really more a signal that the correction when a bit ahead of itself and that we are due for some air.
2. It doesn't work that well on Bitcoin. In fact, certainly not the 2.5 standard deviation (STD). The 3 or 3.5 STD is probably better. I know you are a BTC investor if you are here, but I decided to share this script since I know that many of you are also invested in the stock market and that we may see a bumpy ride in this market.
3. I sometime use it has one tool to help me decide when to open a position in an individual stock that I was watching. But it doesn’t have the same rate of success for momentum play like with indices. The reason is that individual stock are subject to individual news, so they can hit some very oversold level for a while on a bad news. Or bad news can prevent technical rebound to happen.
4. Use it at you own discretion, we are just sharing here a tool we develop looking at statistic to find real oversold condition. When I say real, it’s in reference as other tool like RSI that can simply stay oversold for long. You will almost never see more than 2 candles that will breach a 2.5-4STD . There is plenty of way to take advantage of this tool and we let you choose your own path that will certainly vary depending on how you manage your risk and play this signal.
We will deliver SMS alerts for this signal when it breach the 2.5 mark. Since the level of breach can change rapidly during a given day we recommend setting up your own alerts. If you don’t know how to do it, simply load the indicator on the ticker you want and go to alerts and choose the level you want. Since a picture is worth a thousand words, here is what I mean: