Most of the time, high probability traders focus on overbought conditions below the 200-day moving average, not above it.
This is because our research into short term, exchange-traded fund price behavior going back to the mid-1990s in the case of the ^SPY^ tells us that there is an edge in selling short exchange-traded funds when they are overbought BELOW the 200-day moving average. So for high probability traders looking to trade with strong historical edges on their side, trading overbought conditions below the 200-day is the quantified, backtested way to go for traders looking to sell ETFs short.
However, high probability traders may still have reason to monitor overbought conditions in ETF markets trading above the 200-day moving average. As these markets become more and more extended to the upside, the likelihood that they will experience a pullback or correction increases. And it is in these corrections that high probability traders find their trading opportunities to the long side.
Because of this, rather than ignoring ETFs as they soar higher and higher above their 200-day moving averages, high probability traders should keep an eye on these markets. It is no exaggeration to say that many of the ETF markets trading in overbought territory above the 200-day moving average today are some of the same ETF markets that will be pulling back – some sharply – tomorrow.
So let’s take a look at some of the most overbought markets in exchange-traded funds, with an eye toward anticipating potential reversals when traders who have been chasing these markets higher all make a rush for the exits at the same time.
The question of whether or not bonds are “in a bubble” has made frequent appearances in the financial news headlines. From a high probability perspective, we can see in exchange-traded funds like the ^TLT^ and the ^AGG^ (below) a number of consecutive closes in overbought territory above the 200-day. Both funds, for example, have not closed in oversold territory since the beginning of the month.
Whether or not bonds are in a bubble, high probability traders should steer clear of the long side of the bond ETF market until bond ETFs begin closing in oversold territory.
The same is somewhat true for gold ETFs, as well. Despite a one-day dip into oversold territory earlier this week, the ^GLD^ has not closed in oversold territory since late July. The same is true for the ^IAU^ (below).
By some contrast the ^GDX^ is moving higher after a quality pullback above the 200-day moving average. The fund closed in oversold territory above the 200-day moving average for two consecutive trading days to begin the week.
And Wednesday’s move higher likely provided the necessary strength for high probability traders who took advantage of the oversold GDX to lock in gains on the close.
Other ETF markets that are becoming more and more overbought above the 200-day moving average and increasingly due for a reversal
include: the ^LQD^, the ^SLV^ and the ^DGP^.
With 7 professional, quantified trading strategies for trading both bull and bear markets, High Probability ETF Trading by Larry Connors and Cesar Alvarez was voted one of the top 10 trading books of 2009 by SFO Magazine. Click
here to find out why.
David Penn is Editor in Chief at TradingMarkets.com.