When markets are trading in bear market territory, the biggest edges for short term traders are in selling markets when they become overbought.
While it is tempting – and easier psychologically – to sell or sell short markets after they have already moved lower, the data shows that, in the short term, the better way to sell markets short is to wait for them to rally and become overbought first – the more overbought the better.
Take a look at how one market, the iShares MSCI Emerging Markets Index Fund ETF (EEM), has traded since slipping into bear market territory in early August. Almost every time the ETF has made two or more consecutive closes in overbought territory (defined here as a 2-day Relative Strength Index or RSI of 70 or more), the fund has sold off sharply.
Consider EEM’s four-day rally in late August. Four days up in bear market territory, the last three overbought, and EEM sold off for the next three sessions in a a row. A pair of overbought closes in mid-September led to a sell-off that sent shares of EEM lower by more than 11% in four days.
Other examples of the fund selling off after rallying into overbought territory include bear market rallies in late October and as recently as this week. Down more than 4% on November 9th, the iShares MSCI Emerging Markets Index Fund ETF has again sold off after consecutive closes in overbought territory.
In fact, out of five separate occassions since early August when EEM dropped into bear market territory, four of them resulted in sizable sell-offs. And while this sample size is obviously small, this 80% accuracy rate is consistent with what quantified backtesting has revealed about basic, ETF high probability mean reversion strategies such as these when studied since inception. This research was first published in the book by Larry Connors and Cesar Alvarez, High Probability ETF Trading: 7 Professional Strategies to Improve Your ETF Trading.
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David Penn is Editor in Chief of TradingMarkets.com