Sunday, October 30, 2011

Overbought markets and how to trade them

Its been a great month for the bulls and its now time to turn to McClellan Oscillator to see if the markets are overbought here. While an indicator that calls tops and bottoms perfectly does not exist and will never exist, McClellan Oscillator in my opinion, is fairly decent in determining overbought and oversold conditions. The overbought levels are marked on the Nasdaq and NYSE McClellan Oscillator charts below.

An overbought market can easily become "more overbought" just as an oversold market can easily get "more oversold", but the odds greatly favor a pullback or a period of consolidation here.

How to trade these 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. 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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