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Chartists can identify overbought and oversold levels by measuring the how far extended a security has become from its moving average. This can be shown with two indicators: Moving Average Envelopes and the Percent Price Oscillator (PPO). Moving Average Envelopes show two parallel lines that are a specific percent above and below a moving average. The Percentage Price Oscillator (PPO) is a momentum oscillator that shows the percentage difference between two moving averages.
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The chart above shows the S&P 500 ETF (SPY) with Exponential Moving Average Envelopes set 2.5%, 5% and 7.5% above/below the 50-day EMA. The pink dotted line shows the 50-day EMA for reference. The indicator window shows the Percentage Price Oscillator (50,1). This shows the percentage difference between the 50-day EMA and the 1-day EMA, which is the closing price. Because the Percentage Price Oscillator uses exponential moving averages, chartists should select “EMA Envelopes” for a proper comparison. Notice how movements above/below the Moving Average Envelopes correspond to movements in the Percentage Price Oscillator. The PPO hits -7.5% when price hits the -7.5% envelope. The PPO hits +2.5% when price reaches the +2.5% envelope. The PPO hits 5% when price reaches the +5% envelope.
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The chart above highlights the overbought (red arrows) and oversold levels (green arrows). Working from left to right, we can see that SPY moved lower in May and June with several forays below the -5% envelope (red). SPY became oversold just above the -7.5% envelope (green) at least three times and bounced. The early August surge to the +2.5% envelops showed strength that foreshadowed an extended uptrend. This envelope also marked a short-term overbought condition that led to a pullback. The ETF found support near the -2.5% envelope in late August and surged above the +2.5% envelope in mid September. Notice how SPY continues to hold above the +2.5% envelope. This is a classic case of becoming overbought and remaining overbought.
