Monday, September 13, 2010

Overbought markets and how to play them

After four consecutive up days in the market, its once again time to check if the markets have reached overbought levels. And that, of course, means its time to turn to the trusty ol' McClellan Oscillator for guidance. Attached below are the charts of Nasdaq and NYSE McClellan Oscillators with the overbought levels marked on them.

As we can see from above, the markets are trading just above overbrought levels after today's action. Now that does not mean that we head straight down from here. There is no doubt that today's action was very bullish. But keep in mind the markets are approaching important resistance levels. The following is from a post I had written a while back on how to trade overbought markets with some additions and hopefully its of some use to you readers out there.

How to trade overbought markets?

(1) Don't go chasing momentum stocks now. Chances are you will be left holding the bag.
(2) Take partial profits from longs and let the rest run. 
(3) Don't wait to sell at the top. Calling the top is a fool's game.
(4) If you want to go short, start with a small position. This way you can give it room to run instead of being forced to call the exact top. If the market indeed reverses, you will get plenty of chances to add to your positions later.
(5) Most importantly, keep your stops on all short positions no matter how confident you are of a pullback here. An overbought market can easily become "more overbought" just as an oversold market can easily become "more oversold". Remember, the markets can stay irrational a lot longer than you can stay solvent. The above assumes that you are rational in the first place :).
Take care and good luck!

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