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How to time market tops and bottoms
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How to time market tops and bottoms


October 7, 2019
How to time market tops and bottoms

Buy low, sell high. It’s probably the most clichéd trading truism ever spoken. Even people who have never seen a chart in their lives have heard it. However, anyone who’s ever traded with real money has found to their frustration that in practice buying low and selling high is much easier said than done.

If there really were a reliable way to identify market tops and bottoms, it would be like a license to print money or like being in possession of a goose that lays golden eggs. It would be like having Michael J Fox’s sports almanac from Back to the Future 2. But are there any ways to at least increase your odds of getting it right? Are there any sound words of advice to help you with such a difficult task?

Technical indicators are just a guide

It’s important to keep in mind that technical analysis is only really a guide as to what’s going on. You probably shouldn’t use the data from any one technical indicator in strict isolation as a buy/sell signal. RSI is a perfect example of this.

RSI, or relative strength index is one of the most widely used overbought/oversold technical indicators that traders use to identify tops and bottoms. The conventional wisdom goes that when RSI hits 70 it’s a sign that the asset in question is overbought and when it hits 30 the asset in question is oversold. These levels are usually thought of as signalling imminent turning points.

However, in practice, sticking blindly to this logic will cause you to blow up your account in no time. Why? Because markets can carry on being overbought or oversold for ages. RSI levels can surge beyond 70 in the case of a euphoric bull market that breaks its all-time highs. Similarly, they can plunge below 30 and stay there for a long time, as many bear market veterans will tell you. If you’re relying exclusively on RSI to tell you when to sell the top or buy the bottom, you could be in for a bad time.

How to time market tops and bottoms
The bitcoin price chart at the daily timeframe. In figures 2, 3 and 4 below we’ll zoom in to the hourly timeframe and examine the above buy and sell signals in more detail

Look out for divergences

A good way to still use RSI but not be a slave to the numbers it generates, is to look out for divergences between what the RSI indicator is telling you and what the price action is saying. This is a much more reliable way to trade tops and bottoms without losing your shirt.

In the image above we have identified three tops (selling opportunities) and two bottoms (buying opportunities) at the daily timeframe of the bitcoin price chart. In the following examples we’re going to zoom in on these opportunities at the hourly timeframe and learn about how divergences can help us identify possible tops and bottoms.

The reason we’ve chosen bitcoin is that it’s a market where everything occurs in a more condensed period of time, with more pronounced tops and bottoms. This is partly due to the fact that it trades 24 hours per day, 7 days a week, but also because it’s a much more volatile and fast-moving market.

Of course, to a certain extent, this means that we’re sort of cherry-picking our data here, but this is only for the sake of illustration. RSI divergences are a legitimate trading strategy that can be applied to any and all markets.

How to time market tops and bottoms
Bitcoin’s price chart zoomed in to the hourly timeframe to show the first sell and buy signals highlighted in Figure 1 above.

Notice how the RSI actually tops-out before the price does. If you were trading the above chart using RSI on its own, you would have received a sell signal way in advance of the price topping-out. If you had taken a position when RSI first hit 70, or even when it rose above 80 (the first black arrow) not only would you have gone in too early and missed the top, but if trading on margin you would have been in trouble as the price continued to rise.

However, using RSI divergence as your strategy, the first sell signal actually comes not when RSI breaches 70, but when the price sets a new high and the RSI fails to do so, setting a lower-high instead (the second black arrow). This is a sign that the strength of the price move is starting to lose steam and it’s an indication that a reversal could be imminent.

The same is true of the first buy signal. As you can see above (the third black arrow), the RSI bottoms-out first, it looks like the price is going back up, but then there’s a sharp move down to $9600, a new lower-low while the RSI sets a higher-low at around 40. This signals that the bears could be running out of steam and indicates that a new move up may be in store.

The two signals above, read in this way would have indicated a sell the top and buy the bottom scenario. Of course, hindsight is always 20/20, but let’s move on to the next two signals and see if this RSI divergence methodology held true.

How to time market tops and bottoms
Bitcoin’s price chart zoomed in to the hourly timeframe to show the second sell and buy signals highlighted in Figure 1 above.

Once again, you can see the RSI becoming very overheated before the price tops-out (the first black arrow). If you were employing this strategy, you would have refrained from taking a position until the next move higher and then waited for confirmation from the RSI setting a lower-high while the price was setting a higher-high (the second black arrow).

The same is true of the buy signal (third and fourth black arrows). Although in this case, as you can see above, the divergence is nowhere near as pronounced as in the previous examples. As we saw in Figure 1, the chart shows bitcoin in an ever-tightening range. In such cases, the power of each subsequent move becomes progressively smaller. When this happens divergences also become less pronounced, so you can only really use this strategy a few times in a tightening range before the signals start becoming less clear.

In any case, as you can see above, the price dips, RSI becomes oversold, then the price dips even lower but the RSI fails to drop lower than on the first dip.

How to time market tops and bottoms
Bitcoin’s price chart zoomed in to the hourly timeframe to show the final sell signal highlighted in Figure 1 above.

Finally, we come to our last sell signal example. Following a pronounced move up, RSI tops-out as the price trades around $11800 (the first black arrow). After a brief period of consolidation, the market rallies onwards to $12,200 but the RSI shows signs of momentum cooling off, again setting a lower-high to the price’s higher-high (the second black arrow).

We’ve seen this pattern repeated for three tops and two bottoms in a three-month period, demonstrating that RSI divergences do hold true. They may not be a crystal ball, however, they do work enough of the time in order to make a useful addition to your existing RSI strategy.

You don’t have to capture both sides of the price move

My first trading mentor gave me a very valuable piece of advice that still informs how I look at markets today. He was adamant that trying to catch both tops and bottoms doubles your risk and your chances of failure. According to him, the long and short sides of the trading game are completely different styles of trading that require a different combination of skills and mindset.

His advice was to pick the side that you’re temperamentally best suited to and focus on that. In other words, if you’re a long trader, focus on picking bottoms and leave the tops to the short sellers. Similarly, if you’re a short trader, focus on picking tops and leave the oversold conditions to the bottom-fishers. There are key psychological differences between the long trade and short trade games and it pays to be mindful of this fact.

It’s a very simple, sound and indeed obvious piece of advice that so often gets overlooked. That’s not to say that it’s impossible to trade both sides, as many traders do. But the point is that trading is a game of probabilities, where your main priority should be to focus on maximizing your edge and minimizing all the things that end up costing you money. It’s a long game, no-one catches all the tops and bottoms. Narrow in on what you do best, focus in on that and be selective with the trade setups that you choose to play.

 

Disclaimer: This article is not investment advice or an investment recommendation and should not be considered as such. The information above is not an invitation to trade and it does not guarantee or predict future performance. The investor is solely responsible for the risk of their decisions. The analysis and commentary presented do not include any consideration of your personal investment objectives, financial circumstances or needs.

Risk Warning: Our products are traded on margin and carry a high level of risk and it is possible to lose all your capital. These products may not be suitable for everyone and you should ensure that you understand the risks involved. Please read the full Risk Disclosure Statement.

 

October 7, 2019