Going into trading on Wednesday, it is hard to imagine the markets being more overbought than they are right now. And when stocks and exchange-traded funds (ETFs) are closing higher and higher day after day, high probability traders turn their attention to leveraged exchange-traded funds (ETFs).
I have talked about this before (most recently in this column, Short Term Trading Strategies That Work: The Temptation of Buying Overbought Markets). The principle of buying markets that are oversold and selling markets that are overbought initially becomes difficult when markets are simply driving deeper into overbought territory and providing no pullback-buying opportunities – opportunities that are the lifeblood of high probability trading.
The solution, however, is available in the form of leveraged ETFs, especially inverse leveraged ETFs, that are only becoming more oversold as the broader market of stocks and non-leveraged exchange-traded funds is becoming more overbought.
With leveraged ETFs, high probability traders typically wait for oversold conditions to become very extreme before taking positions – more extremely oversold than regular stocks. This discipline helps high probability traders catch leveraged ETFs at precisely the levels at which they have historically stopped pulling back and begun to reverse and move higher. This approach, combined with scaling-in strategies that call for adding to positions as the edges grow, is one that a growing number of high probability traders have begun to adopt to make sure that their trading strategies and their trading portfolios are able to take advantage of every market condition – from advancing markets to declining markets, as well as markets that are moving side to side.
Here are some of the inverse leveraged ETFs that high probability traders should put on their watchlists for the next few days. Given the already overbought condition of the broader market, traders should not be surprised if many of these inverse leveraged ETFs begin their reversals to the upside sooner than many expect.
Among the most oversold, equity index exchange-traded funds are two that correspond to the Nasdaq 100: the ^QID^ (below) and the ^PSQ^ (which is an inverse fund, but is not leveraged).
Shares of QID have closed lower for five straight trading days, closing in oversold territory for the past two sessions. The last time the QID was this oversold was back in early July, during the ETF’s descent to the mid-August lows. The same is true for the PSQ, which has also closed lower for eight of the past nine trading days.
The ^EEV^ (below) closed in oversold territory for two days in a row before bouncing modestly on Tuesday. That bounce was enough to lift the ETF up from its most extreme levels, leaving EEV just outside of technically oversold territory.
As I note below in the discussion of Indian equities, the strength in a number of developing markets is playing a large part in making the EEV among the more oversold leveraged ETFs in our database, despite Tuesday’s small move higher.
Speaking of developing markets, buyers remain aggressive in Chinese stocks, helping the ^FXP^ (below) drop to new lows ahead of Wednesday’s trading.
Shares of FXP dropped sharply on Monday and essentially tread water on Tuesday, remaining at the oversold levels from the previous day’s gap down. FXP is trading at its most oversold levels since early August, a low that anticipated the exchange-traded funds rally from just under $34 to well over $37 in eight days.
Like the ProShares UltraShort MSCI Emerging Markets Index Fund ETF, the ^MZZ^ also bounced modestly on Tuesday. However unlike EEV, MZZ remains very much in deep oversold territory, marking its second consecutive close at those levels as of yesterday. The last time MZZ was this oversold was in early July during the fund’s gradual mid-summer pullback.
One ETF that is not on this list that should be is an inverse leveraged India ETF. Right now, two out of the top three most overbought ETFs (non-leveraged) are related to the Indian stock market: the ^EPI^ and the ^INP^. Both of these exchange-traded funds have 2-period RSIs of more than 99 – exceptionally high readings for country funds. Unfortunately, both ETFs are trading above their 200-day moving averages, and as such are not suitable for selling short. But this is a prime example of how an inverse leveraged ETF – an ETF that was becoming more oversold as ETFs like the INP and the EPI are becoming more overbought – could be an excellent tool for short term traders looking to take advantage of all the opportunities the market provides.
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.