Measuring overbought and oversold conditions can be tricky with Price Channels. Securities can become overbought and remain overbought in a strong uptrend. Similarly, securities can become oversold and remain oversold in a strong downtrend. In a strong uptrend, prices can move above the upper channel line and continue above the upper channel line. In fact, the upper channel trend line will rise as price continues above the upper channel. This may seem technically overbought, but it is a sign of strength to remain overbought. Similarly, the Stochastic Oscillator can move above 80, which is technically overbought, and remain overbought for an extended period.
Successful use of overbought and oversold levels depends on successful trend identification. Once a bigger uptrend has been identified, traders can look for oversold levels in the smaller trend. Short-term oversold levels occur after a pullback within a bigger uptrend. As noted above, the weekly charts turned bullish when QQQQ surged above the upper channel line. Once the weekly chart is bullish, traders can turn to the daily chart to look for oversold signals. The weekly chart represents the bigger trend, while the daily chart represents the smaller trend.
The chart above shows daily prices for QQQQ. The bigger trend (weekly chart) is up so we would be looking for pullbacks on the daily chart. The green arrows show when QQQQ dipped below the 20-day Price Channel. There were two good signals in early July and early November. There were three touches in January-February. The first two signals were “early”, while the February signal was a direct hit.
Inverse logic can be applied in downtrends. A weekly downtrend starts with a plunge below the lower channel line. Once this downtrend is established, chartists can turn to the daily chart to look for overbought signals. Overbought signals occur after a bounce within a bigger downtrend. Downtrends tend to be faster than uptrends. This means overbought readings may not occur during a strong or fast downtrend. Chartists may then need to tweak the Price Channel settings or use the centerline for signals. Prices are more likely to touch the centerline than the upper channel line.
Price Channels tells us when a security reaches an xx-period high or an xx-period low. 20-day Price Channels mark the 20-day high-low range, 10-week Price Channels mark the 10-week high-low range. The centerline marks the midpoint. Securities that continuously exceed the upper channel line show strength. After all, it takes strong buying pressure to forge higher highs. Conversely, securities that continuously break the lower channel line show weakness. Strong selling pressure is evident with lower lows. Using Price Channels, chartists can determine the dominant force, buying pressure or selling pressure. As with all indicators, it is important to use other analysis techniques to confirm or refute the Price Channels. Chartists can use chart patterns, indicators or basic chart analysis to complement Price Channels.