3 Ways To Play This Overbought Market
Over
the past week, the market has continued to rally strongly. Pullbacks
are lasting hours rather than days, and bad news in one area of the market is
not carrying over to others. An example of this would be the Semis (SMH) and disk
drive sectors today. While they had a tough time and brought the Nasdaq down a
little, the S&P 500 and Dow were unphased and marched higher. There have been
scores of breakouts every day lately. While breakouts always have mixed success,
I’ve noticed several stocks recently that have really powered higher. There
have been numerous solid trading opportunities and more stocks are continuously
setting up. Price-and-volume action on the exchanges has also been good.
The problem with the fact that everything
is looking so rosy is it’s creating a fair amount of complacency. People
are getting excited about investing again, and they don’t want to miss
out on this great move. None of the major indices has experienced a three-day
pullback in over a month. Meanwhile, the VIX closed today at its lowest level
since 1996 and is now more than 10% below its 10-day moving average. The environment
is getting short-term dangerous and most readers of this site are probably already
aware of it.
So the question then becomes: How
do you play a short-term overbought market in an intermediate-term solid uptrend?
If you’re a reversal
player, the answer is obvious…you look for a signal to short and try and
make some money on the inevitable pullback. Keep in mind this will be a counter-trend
trade, though. Don’t overstay your welcome, hoping that you’re catching
the top of a longer move down. The higher probability and potentially more rewarding
trade in an intermediate-term uptrend is buying when the market is short-term
oversold, but that’s not happening right now.
If you’re a growth investor,
things become a little more complex. Do you stop buying because the market is
due for a pullback? In my opinion…no. I’ve said it before, and I’ll
say it again, if a stock that meets your criteria sets up and triggers, take
the trade. Always. In high-risk environments I
believe you should simply take some extra precautions. Demand the best setups.
Don’t take trades that you consider “close callsâ€. Keep your
stops a little tighter. Consider trading with reduced position size. If a trade
doesn’t follow through pretty quickly, scratch it and move on. But if
the trade is there, and it’s a stock you want, take it. You never know
which of your trades are going to turn into big winners. There’s no sense
passing up on a good stock because you think the indices are probably going
to pull back a little.
Another strategy to consider would
be to hedge part of your long position with a short index trade. Keep in mind
you are just looking for a temporary hedge and you should treat the position
as a reversal trader would. Look to lock in some profits if the trade moves
in your favor and don’t overstay your welcome.
Once the market does pull back for
more than a day or two, I might start getting more aggressive again. I especially
like buying stocks that break out when the market is in the process of correcting
(assuming it doesn’t turn into an intermediate-term correction). Some
of the most reliable breakouts often occur on down market days. A stock that
can manage to break out strongly on a day where the market is struggling is
exhibiting exceptional strength, and demands attention.
Best of luck with your trading,
Rob Hanna
robhanna@rcn.com