In the trading universe, you often hear from people who claim that a particular market was overbought or oversold according to their magical indicator – sometimes even gut feeling.
Oftentimes this message implies to be cautious with new commitments and to expect a dirty reversal anytime soon. Unfortunately, the inexperienced trader all too often interprets an oversold condition as a signal to buy into a falling market. If you cannot expect to earn much with the current downtrend anymore, the reward must be waiting on the opposite side, mustn’t it?
Not quite. The general wisdom among trend followers is that as long as a market is falling, support areas are going to give way to the sellers eventually. What appears to be support for a moment will henceforth break for new lows because of an underlying bearish force in the market. This indicates that optimistic market participants are not going to succeed in the long run. It is simply the nature of downtrends that buying into them is a very challenging proposition.
How do we recognize a falling market, you ask? You can characterize downtrends as a sequence of lower highs and lower lows in a daily time frame. An uptrend is consequently defined by a sequence of higher highs and higher lows.
Take a Closer Look at Trends
Take a daily chart of the S&P 500, for example, and look out for decisive lows created during an uptrend. As long as visibly striking intermediary lows have not been taken out by the bears, the trend is still regarded positive. Shorting in an uptrend is a fool’s game.
How can we trade an “overbought” market then? If you are in a position already, the easiest answer is to evaluate whether a tighter stop-loss makes sense. Set it to the most recent low that was formed on the way up to protect your profits, and continue to participate in the current trend. We will never know whether the next reversal is for good, so trailing the stop-loss order would yield the most desirable outcome.
If you have no position, be on the lookout for promising entry opportunities during reversals. You want to make sure that you are entering during a turnaround at a trough. Use the daily time frame as a reference for the bigger picture, and use the 1-hour time frame to trade an actual reversal pattern therein.
Identify visually striking support or resistance areas and observe the price when it is smashing through them with momentum. An example would be the break of an intermediate horizontal resistance. That is your potential buy entry to participate in an uptrend.
You should not jump into the market or close out a good long position in panic just because some random trader shouts “overbought”. Stick to your trade as long as there is not enough evidence for a turnaround. What can be more painful than a loss is to close out and bitterly see how everyone else continues to profit from the trend you used to be in.