Adjusting Overbought and Oversold Rate of Change Levels for Market Trend

The levels at which momentum indicators can be considered “oversold” (with the market likely to try to firm, especially during a neutral or bullish period) and “over bought” (with the market likely to at least pause in its advance, especially during i bearish or neutral period) often vary depending upon the general market climate.
During bullish market periods, rate of change readings rarely reach the negativty extremes that can exist for many weeks or even months during bear markets. Where they do decline to their lower ranges, the stock market frequently recovers rapidly During bearish market periods, rate of change readings tend not to track at levels a: high as those during better market climates; the stock market more likely decline rapidly when readings reach relatively high levels for bear market periods
When assessing whether momentum indicators suggest an imminent market reversal based on overbought or oversold levels, adjust your parameters based up the market’s current price trend, moving average direction, and rate of change parameters that are currently operative. These adjustments are, of course, somewha subjective rather than completely objective.
For the most part, significant market advances do not start when rate of chang and other momentum oscillators stand at their most negative or oversold reading! They tend to begin after momentum oscillators have already advanced from their most negatively extreme readings. The October 2002 advance did not start until the 21-day rate of change oscillator had ahead established a rising, double-bottom pattern, the second low point of which was corsiderably higher than the first.
The end of the November-December market advance did not stand until the 21-day rate of change oscillator had already retreated from its peak level with a descending double-top formation created in the process.
The summer 2002 decline did not end until rate of change measurements established a pattern of rising lows (diminishing downside momentum). A divergence developed within Area A on the chart; the price level of the Nasdaq 1 (Index fell to new lows, whereas its 21-day rate of change level did not. You can already see a minor-tern but nonetheless significant secondary positive divergence in A n B, with prices declining to a final low while rate of change measurements became less negative.
The recovery from the lows of September 2002 developed in a classical fashion. The first step was a strong leg upward that carried prices above a resistance an (the peak in August) and momentum readings to high levels, more positive than any time since March. However, the initial spike came to an end after approximately two months.
Was there a warning of the forthcoming two-month decline? Yes, indeed. Check out Area C on the chart, the area in which prices rose to new recovery peaks in November while rate of change levels declined, a classic negative divergence that foretold developing market weakness.
The dedine in the stock market in Area D appeared to be developing from a bearish-looking head and shoulders market top formation (defined as “Bottom Fishing, Top Spotting, Staying the Course: Power Tools That Combine Momentum Oscillators with Market Breadth Measurements for Improved Market Timing”), but the positive divergence (lower prices unconfirmed by rate of change patterns) that developed in January 2003 argued for a more favorable outcome, which did develop.