2 Ways to Trade Overbought Stocks

03/23/2011 6:00 am EST

Focus: STOCKS

Corey Rosenbloom

Founder and President, Afraid to Trade

A simple screen is used to identify stocks that may have risen too far too fast, and from there, traders can choose from a couple distinct strategies in order to profit from these conditions.

By Corey Rosenbloom

I’ve written in the past about a simple screener tool that highlights the five most overextended stocks from their 200-day simple moving average (SMA) and how you can use the data in different ways.

Let’s start with the top five overextended stocks as of March 21 and then see what strategies may be used:

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Courtesy of the screener tool at FinViz.com, we can see not only the top five overextended stocks, but we see a cluster of these stocks in the same sector: Basic Materials. They are:

  1. Tesoro Corporation (TSO)
  2. National Oilwell Varco, Inc. (NOV)
  3. Massey Energy Co. (MEE)
  4. CB Richard Ellis Group, Inc. (CBG)
  5. Cabot Oil & Gas Corporation (COG)

That alone gives us information that the Basic Materials sector is doing quite well, and in fact, broader sector rotation data currently show that. Savvy traders and investors may want to dig around more in the stocks in this sector, particularly given the rises in commodity prices.

But that’s a different issue.

These are the top five stocks in the S&P 500 when looking at the percentage the stock is extended above the 200-day simple moving average (SMA). Traders who “fade” the markets look at these types of movements as unsustainable and will watch them closely for a top and reversal.

For example, Tesoro Corp (TSO) is 63% extended from the average:

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The goal with this type of screen is to find the most powerful (or uptrending) stock in the market based on difference from a known reference level—the 200-day SMA. You would look individually at the fundamentals (if investing) or technicals/charts (if trading) to get a better sense of what your next play might be.

For example, TSO has been rising strongly off its 20- and 50-day exponential moving averages (EMAs) consistently, and it may continue to do so.

If it begins to break down, then we have an opposite “fade” play, particularly with a trigger on a breakdown under the $22 level.

That’s the main way to use this scan; or at least is my interest in doing so.

Running this quick scan allows for two separate strategies:

  1. Find powerful, impulsive stocks in an uptrend where you can buy them on breakouts to new highs or on retracements into support

  2. Find overextended stocks late in an uptrend that break down, where you play “fade” or reversal strategies

Personally, I’m more for the “Find strength and play strength” strategy, but there are many traders who have built their trading businesses by playing “fade” strategies from overextended stocks.

It’s like the logic “What goes up must come down” or “The higher they rise, the harder they fall,” and while this logic is applicable to many things in life, it doesn’t always work in leading stocks—think Apple (AAPL), for example.

For reference, the stock most under-extended from its 200-day SMA is Tellabs (TLAB), a technology company that just retested a new 52-week low as of March 21.

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The same logic—only in reverse—goes for most stocks that are under-extended (or “overextended to the downside”) as well.

With these types of scans, be aware that small share prices—like $5.00, for example—will overemphasize the percentage difference. Anyway, the benefit of this type of simple screen allows you to make your own decisions, and it presents you with names of stocks you might not otherwise find.

By Corey Rosenbloom, trader and blogger, AfraidToTrade.com

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