Trading Safely in an Overbought Market

04/05/2011 7:00 am EST

Focus: STRATEGIES

Overbought conditions like we may be seeing now make for a dangerous trading environment. Take steps to ensure proper risk control and don’t fall victim to a sharp, quick pullback.

While it may sound like a misnomer, buying during a strongly trending market can often be very difficult, especially the further into a move it becomes.

The reason for this is that after a few days of trending higher, the vast majority of stocks become extended, and thus, they offer inferior risk/reward set-ups. Even though many of these stocks will continue to rise through overbought conditions, the bottom line is that most stocks will be vulnerable to profit taking due to even just a typical pullback to support.

During strong market periods, traders are constantly faced with the difficult choice of deciding when a stock is too extended for a safe entry. So how do traders protect themselves while staying exposed to the market? By not chasing extended stocks and focusing on stocks with good risk/reward entries.

What I typically look for in a trade set-up is a situation where I am risking as little as possible with the potential to earn a large multiple of that risk. The below set-up in InterOil Corporation (IOC) is a good example of what I mean by choosing a good risk/reward set-up. IOC cleared a descending trend line that was outlining the current base in mid March. Oil stocks have been very strong, and IOC is trading just below all-time highs. Clearly, the potential for gains is here.

However, the initial breakout offered a very poor risk/reward ratio after rallying in a straight line from $68-$80. IOC pulled back to its breakout area and has now settled into a tight range near $75. This is offering a good opportunity for traders willing to buy on any strength that takes IOC above this narrow range. Basically, a trader would be risking roughly two or three points for the opportunity to earn six or more points, and possibly much more if IOC busts out to new all-time highs.

Of course, IOC could easily fail if the markets pull back, but the idea is that you are choosing a trade set-up that allows you to place a very tight, but realistic stop, which allows you to take a small loss when wrong.

chart
Click to Enlarge

Buying a stock that is extended from its base forces a trader to either place their stop in a spot that will likely get hit during a normal fluctuation, or worse yet, sit through a pullback that is much deeper than they expected.

In a typical market, a trader can get away with a sloppy trade or two, but in an overbought market, the possibility of a sharp one- or two-day down move increases, making it dangerous for careless traders.

The market is starting to become overbought already, with the McClellan Oscillator* already at levels associated with short-term tops. In this environment, focus on minimizing your risk and let the market take care of the rest.

By Joey Fundora, trader and blogger, Downtowntrader.com

*See also The McClellan Summation Index: The Mother of All Market Timing Tools

Related Articles on STRATEGIES