Are Stocks Overbought?

Dear SlingShot Trader Subscriber,

The term ‘overbought’ means that buyers (or at least new buyers) are exhausted and will be unable to drive prices higher. This could leave a surplus of sellers in the market and a sharp correction is possible. On the surface it seems like traders should buy oversold stocks and sell overbought stocks to make profits. However, defining those conditions in the past-tense is much easier than in the present.

Hindsight is Always 20/20

Technical indicators are often used to define overbought market conditions; however, overbought signals from a technical indicator can just as easily be a signal that a trend is in play. If a trend is in force, the last thing traders would want to do is dump their “overbought” stocks just as the market is about to go on another bullish extension.

We can do a lot to differentiate between a trend and a truly overbought market by looking at the context of the technical signal. If indicators are signaling an overbought condition but volatility is low and the trend is positive, traders should be much more skeptical that the market is truly overbought. But if the market or a stock is in a channel, then overbought signals can be a lot more reliable and should motivate traders to take action.

Google (GOOG): Chart Courtesy of MetaStock

 

In the previous chart, you can see a classic analysis of overbought or oversold market conditions on Google (GOOG) during the past 18 months. These were signaled by MACD divergences, which is a common way to identify these signals.  The four divergences that appeared were unusually accurate because GOOG was stuck in a wide channel rather than a trend. If GOOG had been in a smooth, quiet trend with higher highs and higher lows, the signals would have been more unreliable.

Forecasting the Present

Therefore, the real question seems to be not whether stocks are currently signaling “overbought” but whether they are in a trend or not. In the next chart, you can see both the overbought signal that has been stressing traders within the context of prior highs on the S&P 500. It will always be a judgment call but this looks more like a channel than a trend and a pullback is possible.

S&P 500: Chart Courtesy of MetaStock

What’s the Bottom Line?

Trading an overbought market is not about shifting to all bearish positions immediately, but it does inform our trade selection process and bias. At this point, we will be shifting to a slightly more balanced outlook and will look for opportunities to buy puts on overbought stocks before major news announcements, as well as calls on oversold stocks as we have been doing lately.  The good news is that corrections (even a short one) can produce some big moves, which can turn into big profits for us.

 

This Week’s Events

Here are some of the news events that we may trade in the next week or so. We’ll be discussing some of these in tonight’s webinar.

Mar. 1 – U.S. ISM Manufacturing PMI

Mar. 1 – Weekly unemployment claims

Mar. 1 – Bernanke testifies (again)

Mar. 7 – American Eagle (AEO) earnings announcement

Mar. 7 – ADP Non-Farm Payrolls

 

TRADE REVIEW

When it’s time to open or close a trade, we’ll send you alerts via e-mail. You also can sign up to receive text messages regarding our trades. For more info about our SlingShot Trader portfolio, you can read trade alerts here and view our portfolios here.

Positions Opened

These are the SlingShot Trader positions we opened during the past week of trading that we have not yet closed.

Office Depot (ODP) – On Feb. 23, we recommended you to “buy to open” the March 3 Puts for $0.40 or less. We are still holding this trade but do not recommend new entries.

Big Lots (BIG) – On Feb. 27, we recommended you to “buy to open” the March 45 Calls for $0.95 or less. This trade was closed this morning.

American Eagle Outfitters (AEO) – On Feb. 28, we recommended you to “buy to open” the April 15 Calls for $0.65 or less. We are still holding this trade and recommend it for new entries at our recommended price or less.

 

Positions Closed

These are the SlingShot Trader positions we closed during the past week of trading.

Deckers Outdoor (DECK) – On Feb. 24, we recommended you to “sell to close” the March 85 puts for a profit of 52%.

Big Lots (BIG) – On Feb. 29, we recommended you to “sell to close” the March 45 calls for a profit of 21%.

 

Top Trades Now

These are the current SlingShot Trader positions that we still recommend getting into now, assuming you haven’t already bought a full position.

American Eagle Outfitters (AEO) — See Positions Opened above.

 

Webinar Preview: Join Us Tonight at 6 p.m. ET

Every Wednesday at 6 p.m. ET, we host our live webinar, in which we’ll review this weekly newsletter, discuss coming events in more detail and walk through our Top Trades. We also encourage you to submit your questions live during the session. We want to do everything we can to help you become a successful options trader, which is why you’ll have live access to us for an hour every week.

And if you have any questions or comments you would like to send us in advance of the live session — or anytime during the week — you can write to us at johnandwade@slingshot-trader.com.

If you can’t attend the session live, you can watch the archived version on our website in the “Live Weekly” section. It’ll typically be posted within about two hours of the end of the live session.

Sincerely,

 

John Jagerson and Wade Hansen
Editors
SlingShot Trader