Stock prices are definitely overbought. Overbought markets occur when prices move up sharply, and based on current charts, prices appear to be too high.
This situation actually occurs fairly often. Traders might be tempted to enter a short trade expecting the gains to be at least partially reversed. But that idea has led to large losses for many traders over the years.
Prices might be irrational, but as traders, we need to remember that irrational behavior is irrelevant. Economist John Maynard Keynes supposedly said, "Markets can remain irrational longer than you can remain solvent."
Traders use momentum indicators like the stochastics to decide when prices are overbought. The monthly chart of SPDR Dow Jones Industrial Average (NYSE: DIA) is shown below, and we can see that stochastics has been overbought for more than a year. Based on the stochastics indicator, we can see that bull markets do seem to stay irrational much longer than a short trader could stay solvent.
DIA is being used because it reflects the price changes in the Dow Jones Industrial Average and that index has a price history extending back more than 100 years. When using monthly data, it is usually best to use the Dow because it has so much history.
We can also test what happens after a stochastics buy signal. At the end of May, DIA gave a stochastics buy signal while the indicator was above 90. In the past, this signal has been followed by a brief period of underperformance and then significant outperformance.
The chart below compares the relative performance of buying after a stochastics buy signal when the indicator is above 90 on a monthly chart. Performance is relative to what the Dow has done at all other times. For example, if we normally see a three-month gain of 2% in the Dow, if the three-month performance is 4% after this buy signal the relative performance would be 2.0. If the post-signal average gain is 1%, the relative performance would be 0.5.
In this chart, we see that six months after these buy signals, prices do begin to outperform. This is a visual representation of the idea that the buy signal is followed by a brief pullback that usually lasts about six months. After the pullback, 6-18 months after the initial signal, the Dow has performed significantly better than average.
Not all trades will be winners, but this indicator does offer reliable signals. One year after a stochastics buy signal in an overbought market, for example, the Dow has been higher 82.4% of the time.
Traders looking for a pullback in the stock market might get exactly what they expect. However, that pullback should be considered a buying opportunity rather than the start of a bear market.
Call options could offer an excellent way to trade this idea with less risk. Call options give the buyer the right to buy 100 shares of a stock at a certain price at any time before the option expires. Deep in-the-money calls are options with a strike price that is below the current market price. These calls are more expensive than out-of-the-money calls, which are trading above the current market price. One advantage to the more expensive options are that deep in-the-money calls are more likely to be profitable at expiration.
Calls on DIA with expiration dates in March are available. A call with a strike price of $145 is in the money right now and is trading at about $11.55. This option will be profitable if DIA trades above $156.55, or about 2% above the recent price. The loss on this trade is limited to the amount paid for the option, but a stop-loss should help reduce the risk.
Based on the stochastics buy signal, we expect DIA to trade up to at least $160 before next March. At that price, the call option would be worth at least $15.
We also expect a pullback and would be comfortable entering a buy-limit order to buy this option under $9. It should fall that low if DIA reached $150 on a pullback of about 3%.
Like we said, there's a chance we'll see a pullback soon, but it could get worse. There is a lot of discussion today that we are reaching the peak of a "triple top." The major indices are currently trading near critical levels. In fact, in the years 2000 and 2007, they peaked near these levels. There is a lot more to say about the potential triple top that could send the stock market tumbling, and how to make money regardless of what the market does. Click here for details.
However, there is a chance the market will continue higher, in which case, this order will never be filled. But this is a relatively low-risk, high-probability trade if the order is filled. If the order is not filled within 30 days, we recommend cancelling the order and moving on to the next trading opportunity.
Action to Take -->
-- Buy DIA March 2014 145 Calls at $9 or less
-- Set stop-loss at $6
-- Set price target at $15 for a potential 67% gain in seven months or less
This article originally appeared on ProfitableTrading.com:
Warning: Stocks Are Overbought (And Here's What to Do)