Overbought/Oversold Indicators: When To Use Them–And When Not To
Not
much to say about the market that I haven’t already said. It looks
ugly. This weekend I had less stocks make it through my long-screen for
research purposes than any week since 2002. At this bounce I would view any
bounce as just that — a bounce.Â
Today I want to briefly discuss
extreme conditions and overbought/oversold indicators. As many people noticed,
the selloff last week put several indices at extremely oversold levels. Several
sentiment indicators also began to become extremely bearish (a good thing).Â
These factors helped increase the likelihood that a short-term bounce would
occur. (We got a little one today, which may or may not continue higher.) What
most traders fail to understand is where extreme overbought/oversold are useful
and where they aren’t. Here are my thoughts:
1)Â Â Â Â Â
Oscillators and extreme
readings tend to create favorable trading opportunities in index shares.
— Indices tend to oscillate. They move from overbought to oversold and back
again. Runaway moves are less likely than with individual stocks. Therefore
extreme conditions can most easily and consistently be taken advantage of by
trading index shares, sector etf’s, or some other basket of stocks rather than
individual issues. You should also remember that conditions can remain extreme,
or become more extreme, longer than most people can withstand, so don’t simple
buy and sell based on overbought/oversold indicators. Make sure you have a
complete plan than will provide you with favorable risk/reward.
2)Â Â Â Â Â
A strong move in an
individual stock can easily buck the market for a few days —
In other words, if you look to trade breakouts (or breakdowns), and you find
yourself in and extremely overbought (or oversold) market, some people’s
tendency would be to pass on the trade because they figure the market is due to
reverse. While the market may be due to reverse in the short-term that will not
necessarily determine the success or failure of your breakout/breakdown
opportunity. Therefore, don’t pass on opportunities that meet your criteria
because your general market view is that the market is due for a reversal. If
you feel risks are increased, other measures (like position sizing and stop
placement) can be used to help offset this risk.Â
Take Empire Resorts (NYNY)
for example. At 3:30 on Friday afternoon, the market was already trashed. Most
people were wondering about how to play the bounce, not how to get short. The
opportunity to short had already gone by — not true. NYNY broke down below a
handle of $5.80 at 3:35 on Friday. Today it closed at $3.83. Over 33% lower
than the trigger price. A windfall in just over a day even though the market
was “due†for a bounce.
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The main point is that the
overbought/oversold condition that may exist in the indices will not necessarily
doom new individual trades. The index trade and the individual stock trade are
completely separate and should be treated as such. Rather than allowing one
condition to freeze you like a deer in the headlights, both trades can and
should be taken.Â
Best of luck with your trading,
Rob
P.S.
Click here for the Hanna ETF Money Flow System.
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