A moving average is a technical analysis term used to describe the average price for a stock over a trailing period, usually several days or months. They are used by technical analysts to discover trends in stock prices.
One of the simplest measures of market internals is the percentage of stocks above/below their moving averages. Any moving average can be used, although the most common are the 20, 50 and 200 day simple moving averages (SMA).
This is a useful metric because as stocks move above and below their moving averages, they get stretched away from the average basis that traders or investors entered at. Below is an example of the price and 50-day SMA spread.
Daily Chart of Eastman Kodak Co. (EK) between Jun 09 and Jan 10
Even though the spread between the price and SMA is a good indicator, our tests show that it is not enough to find the most oversold and overbought stocks. The simple reason behind this is the stocks volatility. This concept is overlooked by most of the traders.
Here is what it looks like when we compare the 5-yr historical SMA spreads of two companies.
Red lines represent the standard deviation of the spread
Charts speak for themselves; over 5% spread puts ABT to an oversold/overbought territory, whereas that is over 10% for BBY. So basically comparing the SMA and price relationship of companies to find the most overextended stocks sometimes can be misleading.
So what does “Smart Trading” application offer?
Our financial model computes the oversold/overbought levels for each stock for the 9, 20, 50, 100 and 200-day SMAs by using 5-yr historical spreads and then ranks the most overbought/oversold stocks for each SMA category.
Please note that this application does not provide a forecast for these stocks, but it helps you narrow your research when looking for overextended stocks.