Defensive Strategies For Buying Stocks In An Overbought Environment
After
a sharp pullback on Friday, the market spent the day trying to
reassert its uptrend. Did anyone think a nice little 3-4 day pullback to
support levels was in the works? I hope not if you’d read my columns from last
week. Speaking of which…in last Wednesday’s column I suggested using defensive
strategies when purchasing stocks in an overbought environment. Afterwards I
received s a few emails asking me for an example.
Â
Here’s an example from
Wednesday. After forming a low level cup and handle base, Brocade (BRCD) gapped
up above its pivot point. For those hoping to get in on the breakout, one way
to do it would have been to buy the first intraday pullback. If you’re using
5-minute bars, this would have happened around 10:15. If you’re using 15-minute
bars, 11:15 was the low of the first pullback.
Â
Â
If you’re trading breakouts
defensively, that means you’re insisting on only keeping the best breakouts. If
a breakout isn’t successful right away, get rid of it. Regardless of where my
initial stop was placed, I would be exiting BRCD at the end of the day as it
failed to follow through and close well (about a $0.10-$0.15 loss). Closing at
the bottom of its range, especially on a day where the market was strong, is a
sign that the stock isn’t ready to explode higher. When expecting a market
pullback, I believe it’s better just to cut you’re losses and wait for the next
opportunity. In BRCD’s case, an intermediate-term stop just above the low of
the original handle may turn out fine, but I didn’t think it was appropriate in
an overbought environment.
Â
So why buy any breakout in an
overbought environment? Well, the best ones many times will work right away,
and the potential rewards make taking small risks well worth it. Look at NGPS
which broke out last Monday when many traders were expecting a market pullback –
a very strong breakout followed by a mild two day pullback and a strong continuation
upwards.Â
Â
Â
You wouldn’t have wanted to
pass on that one because you felt the market was short-term overextended…
Â
Best of luck with your trading,
Â
Rob Hanna
Â
Â
Â
Â