How to Properly Measure Overbought and Oversold Conditions (SPX)

By Lawrence G. McMillan

Some analysts occasionally cite the percent that $SPX is above its 20-day or 200-day simple moving averages [when measuring whether a market is overbought or oversold].  The problem with using a straight percentage...is that it doesn't take volatility into account.  In a very dull market, if $SPX is 15% above or below a certain moving average, that may actually be more overbought than if it is 20% above or below that average during more volatile times.  The correct way to handle this, in my opinion, is to calculate the number of standard deviations (σ) that $SPX is above or below the moving average.  That incorporates volatility, and so can accurately compare one market environment with another.

Over time, we have received a number of requests as to how to calculate this figure, so here is a brief summary of the formulae.  I realize this is mostly of interest only to self-avowed geeks and "do-it-yourselfers," but here's how I do it.

1) calculate the 200-day historical (realized) volatility as the standard deviation of daily price changes.  Annualize that by multiplying by the square root of 255 (the number of trading days in a year).

2) solve the following equation for a, the number of standard deviations:

S = Pe^avt
Where P = 200-day moving average
S = current $SPX price
v = volatility from step 1
t = sqrt(1/365)^[1]
or a = ln(S/P) / (v * t)

For reference, at the close of trading on July 23^rd, $SPX was 15.95σ above the 200-day moving average.  That is historically a very large distance, thus qualifying $SPX as "overbought"...

The preceding information was taken directly from The Option Strategist Newsletter Getting Very Overbought, Again article (published 7/26/13).  Read the full article by subscribing today.