Tuesday, March 22, 2005

When does oversold become too oversold? (Ride the trend)

Stephen Vita's excellent Alchemy of Trading blog has been pointing out how oversold we have been lately. He's salivating over the next bounce because he's ready to get long. This got me thinking about a very important issue that every trader should give considerable thought to. Do you try to fade overbought or oversold conditions, or do you use them to make most of your profits? Obviously every situation is different and it depends on what time scale you want to look at. Everybody wants to put the risk/reward equation in their favor, but the problem is that you can't fade extreme conditions and ride the trend within the same time horizon.

My preference is to make most of my gains when the market is stuck in an overbought or oversold condition and not try to fade it. I look for "two steps forward for each step backward" trend opportunities. Since January, when the market has been in decline it has been two steps, and when it has risen it has been one step. I don't know how Stephen plans to trade the long-side bounce, but it takes a lot more work to make money from the single backwards steps than it does from the two steps forward. You can do it successfully though and I'm not doubting Stephen. I may even buy a little bit of GRU if it looks like the market has run out of gas on the down-side and I can get some near its 50-day moving average.

My difficulties in trying to play the single step moves comes from the fact that it takes me two or three steps in the wrong direction to discover that I'm wrong to hold a position. So I'll probably be selling Stephen's step up as long as it is a lower high on the index.


I read a great article by Gary Kaltbaum on yahoo finance today that is related to what I was talking about here.


At 3:49 AM, Blogger Sulli said...

Hi John,

I'm with you man... I've been using the rallies to re-enter short positions. The trend is down and if we are in the next leg of the bear market, "oversold" may not yet be "oversold" so to speak... Those momentum oscillators can very easily bottom out in a swift downturn.

I've been using VIX spikes to help identify near term bottoms and momentum divergences or non-confirmations for near term tops.

Take it easy,
Ryan (Sulli from RDPD)


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