Exhaustion Signals - Profiting when the market is overbought or oversold

Some of the most effective signals I've integrated into my trading system are those based on the principle that the market will become exhausted and the price will begin rising or falling back towards its moving average after a strong upward or downward run. These signals go by various names - I prefer "exhaustion," because it's most vivid and immediately familiar, but terms like "overbought" and "oversold" are equally if not more commonly used. "Contrarian" or "correction" also apply, when used in this particular context.

Recent EUR/USD activity offers an excellent case study in a profitable trading opportunity in overbought conditions - as of this writing, I'm up over 100 pips on a short trade that caught the downtrend pictured in the daily chart to the left. After a major uptrend in the EUR/USD last week, the market is now correcting downwards, presenting a great chance to gather pips by going short.

There are a number of advantages I've found with these types of signals:

• They can be focused on a very specific moment during an uptrend or downtrend, and carefully tuned until they trigger trades at the optimal point in the trend. As a result they are more selective and precise than many other types of signals.

• They can be built around readily available chart indicators such as Bollinger Bands, moving averages, CCI signals, candlestick patterns, and highs and lows.

• When properly designed, they perform with a high degree of consistency. They never score 100%, of course, but then I've never come across a signal that does.

Drawbacks of exhaustion signals are that, well, sometimes the market doesn't get exhausted, and continues on its original course upward or downward. This is something you can expect to happen periodically, and it shouldn't be a surprise that it does - every signal has a failing, and this is the big one for exhaustion triggers. The key when designing these signals, as it is for any signal, is backtesting them extensively with historical data to determine their overall effectiveness and profitability over years of market activity. Only then will you have the confidence in them to execute trades consistently over a long enough period to see positive results.

Here are a few examples of exhaustion signals I use to trigger EUR/USD trades:

• If the market has seen a run-up of X pips over the past Y trading days, I sell the EUR/USD short (don't really feel like giving away my X and Y values today).

• If the previous day's closing price was below the upper Bollinger Band calculated over Z periods, and the high price from two days previous was above the upper Bollinger Band, I sell short. (I use a customized Bollinger equation to calculate my bands, and I'll just say it differs significantly from the standard default Bollingers you'll find in most charting software.)

• If the previous trading day's closing price was above the lower Bollinger Band calculated over Z periods, and the closing prices of the two days before that were below the lower Bollinger Band, I go long (buy) the EUR/USD.

Hopefully these will give you some ideas for designing your own signals for profiting from overbought and oversold conditions. If you have any exhaustion trading strategies you'd like to share, please feel free to post them in the comments.

Related topic:
A Nice Bollinger Band Trade