Wednesday, July 4, 2012

Are the markets overbought?

With the markets being on a tear during the past three trading sessions, its time to have a look at our trusty old McClellan Oscillator to see if the markets are overbought here. Below are the charts of NASDAQ and NYSE McClellan Oscillators with the overbought levels marked on them.

As can be seen from the above charts, the markets are well into overbought territory. The NYSE McClellan Oscillator is in fact, at its highest level in the last two years. While the momentum clearly lies with the bulls, the odds now favor a pullback, or at least a period of consolidation.

Here's how to play these markets.

Do remember that an overbought market can very easily become "more overbought" just as an oversold market can very well become "more oversold". Then how does one play overbought markets? Well, here are a few tips on playing 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. Remember, the markets can stay irrational a lot longer than you can stay solvent. 
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Take care and good luck!

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