Overbought and Rising: How High Probability Traders Trade Runaway Markets

Markets that become overbought and remain overbought are a special challenge for high probability traders.

While this sort of momentum action in stocks and exchange-traded funds (ETFs) makes for great excitement and happy talk in the financial media, high probability traders know that trying to jump on board a moving train – and that’s what buying into a wildly overbought market is like – is not a winning game for high probability traders over the long run.

Why not? Our research into short term trading in both ETFs and stocks tells us that high probability trading – the kind of trading that produces win rates of more than 75% per trade – is built around buying pullbacks, not breakouts – and certainly not through buying markets that are overbought day after day.

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This is true for traders of our ETF PowerRatings as it is for traders of our high probability ETF trading strategies. When markets are overbought and becoming more so, the job of the high probability trader is to be patient, wait and watch.

Where are some of the places high probability traders in general and ETF PowerRatings traders in specific should be watching? One source of potential weakness is in the real estate and REIT market, where a number of exchange-traded funds have begun to pull back. This includes ETFs like the ^RWR^, which earned an ETF PowerRating of 9 as of Tuesday’s close, becoming one of the highest rated funds for Wednesday’s trading.

RWR Chart

RWR has a 2-period RSI of less than 20 and, more importantly, has closed lower for five days in a row.

Another real estate related option for traders to keep an eye on is the ^VNQ^, which earned a top ETF PowerRating of 10 as of Tuesday’s close.

VNQ Chart

VNQ was flat on Tuesday, but had previously closed down for three out of the previous four days. The ETF has closed in oversold territory for the past three consecutive trading days.

One last exchange-traded fund for traders to monitor is the ^IYR^.

IYR earned an ETF PowerRating of 8 as of Tuesday’s close. Also closing lower for three out of the past four days going into Tuesday’s trading, IYR has a 2-period RSI of just under 40.

IYR Chart

Any selling over the next few days will likely result in ETF PowerRatings upgrades for these stocks, which are already among the highest rated funds in our database. By remaining patient and waiting for truly oversold opportunities to appear, high probability traders will be able to take positions and trade with significant, short term edges on their side.

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David Penn is Editor in Chief at TradingMarkets.com.