Hot Money Monday: One potential strategy to beat the market, and how to spot oversold stocks

• What stocks trading at 52-week highs are telling us
• How do we know if they are overbought or oversold?
• We take a look at one investing strategy called the 52-Week High Rotation Strategy

One indicator used by chartists to determine an entry or exit point is the “52-week high” signal, which shows how far or close stock prices are to their 52-week highs.

While most chartists believe a 52-week high means there is a strong chance of momentum ahead, it could also indicate the stock has reached its peak.

Academic studies however have shown that there is a “52-week high effect” –  ie; stocks with prices close to the 52-week highs tend to have better returns ahead than stocks with prices far from the 52-week highs.

Most technical traders therefore view the 52-week highs as entry signals.

A simple explanation is that if a price has broken out above its 52-week range, there must be some factor that generated enough momentum to further continue the price movement in the same direction.

Similarly, if a stock is far away from its 52-week high, chartists believe the momentum will continue going that way.

Here’s one common strategy which has gained acceptance by the chartists community; it’s called the 52-Week High Rotation Strategy:

1. Determine stocks that are trading within 10% of their 52-week highs
2. Then buy the top 5 stocks from that list, and hold for a month.
3. Repeat the following month.

This strategy actually goes against the intuitive “buy low and sell high” mantra, but some traders believe it’s good starting point to building an active strategy to beat the market.

Top 10 ASX small caps nearest or at 52-week highs

Top 10 ASX small caps furthest from 52-week highs

How to calculate momentum on a stock

Others say the 52-Week High Rotation Strategy is too simplistic, and must be refined with other data to determine whether a stock has been overbought or oversold.

The Relative Strength Index (RSI) is one indicator that’s been used widely to gauge that momentum.

How is the RSI calculated?

RSI = 100 – [ 100 ÷ ( 1 + ( U ÷ D ) ) ]

where:

U = the percentage of upward-moving days in the last 14 days
D = the percentage of downwar-moving days in the last 14 days

Let’s say you want to calculate the RSI of a stock over the last two weeks (14 days).

If the stock, for example, has risen 10 times in the last 14 days, then:

RSI = 100 – [100 ÷ (1 + (0.71 ÷ 0.29) ) ] = 71.4

Generally speaking, an RSI above 70 is overbought; and an RSI below 30 is oversold.  An RSI above 80 is strongly overbought, and an RSI below 20 is strongly oversold.

RSI is in effect a measure of the strength of a stock’s momentum, either in the upward or the downward direction.

Contrary to popular belief, RSI is actually a leading (not lagging) indicator, meaning that it can be used to predict future movements.

In the example above, the stock is overbought and is probably due for a correction.

Top 10 ASX small caps with low 9-day RSI (Oversold)

Top 10 small caps with high 9-day RSI (Overbought)