July 28, 2009 at 8:26 am | | Comments 0

Psychology of Overbought, Oversold, and Market Extremes

overdoneEver seen something get just a little overdone?

Perhaps it was that weekend barbecue, or the tattoo collection on that dude you saw the other day.

No doubt, we all run across the occasional extremes, and they’re usually worth a story or two.

It happens in the market too.  Bounces get a bit stretched and before you know it, you’re staring at overbought conditions.  And sometimes selloffs spark a little more damage than usual, creating oversold conditions.

We don’t see ‘overbought’ and ‘oversold’ every week, but it happens regularly.  Emotions are a primary driver of the price action, so it’s no surprise that at times they challenge the boundaries of ‘normal’ and produce market moves with an unsustainable pace.

Every now and then, we’ll see true extremes in the market.  Sometimes it’s when the upside momentum runs so hot that it produces a parabolic uptrend.  Some of the fastest money on the long side can be made during such times, but high risks are there right along with those rewards.  It’s somewhat of a party atmosphere though.  Feels like it might not ever end.

And of course at times we do see selloffs become all-out panics, when capitulation prompts everyone and their dog to sell.  When it happens, it can be rather spooky to see.  Feels like it might not ever end.

What’s the Difference?

There are definitely various degrees of strength and weakness in the market, so let’s take a little deeper look and see what we can pick up and apply going forward.

The fact of the matter is that whether we’re discussing overbought or oversold conditions, or parabolic uptrends or all-out capitulation, the moves in price are happening at an unsustainable pace.

That means it might continue for a little longer, but not forever.  Eventually, some kind of recoil or pullback or reversal is going to arrive, ending the move.  Another might follow in the same direction, but the point here is that price doesn’t move in a straight line forever.

With that said, the biggest factor in determining exactly which condition we’re seeing is going to be the timeframe being referenced.

For example, on an intraday 5-minute chart, a parabolic uptrend can occur.  That same move may leave the daily chart of the same stock hardly even overbought.  So looking under the microscope won’t often correspond to the big picture view.

Faces in the Crowd

As we examine these conditions, it’s crucial that we take notice of all parties involved:  the buyers, the sellers, and those who are short.  Knowing who’s involved and being able to continually evaluate their likely motivations can give us a big edge as traders.  It means we’ll be better prepared for knowing if the move might persist, or if instead we need to be on watch for a sudden shift.  Let’s look at a few situations and the roles which matter most…

First though, a brief description of how I’m using these terms:

Buyer – a bull with cash on hand who wants in.
Seller – a bull with inventory (shares) on hand who wants out.
Short Seller – a bear wanting to get in and profit from a decline.

– they’ll be greedy and eager to buy the first dip.  In an overbought market, the bulls are correct and anxious to add to their positions.  They view it like they’re defending turf, so give them some respect until they show signs of tiring out.

Short Sellers – they’re using strength to initiate reversal plays, but walking the tightrope.  Understanding that they’re putting on short sales at the near-term highs means they’ll likely be quick to cover if more strength arrives.

– they’ve quasi-panicked and dumped when they shouldn’t have, adding some fuel to the fire.  Once they see a bounce or some stability, they’ll likely get long again.  If the bounce fails, they’ve just compounded their mistake, perpetuating the cycle.

Buyers – they’re trying to ‘buy low’ but struggling, because with each new low in price they get spooked and jump ship again.  If a little more pain can be inflicted, they’ll give up.  At that point, they’re vulnerable to getting caught very off guard.

Parabolic Uptrend:
-this is all-out greed.  They’re making money hand over fist, and see no end in sight.  The upside pace has increased, as has their desire for more, and they have no idea that the edge of the cliff is fast approaching.  Once it arrives, they’re in for a shock and they’ll rush for a chair as the music stops.

Short Sellers – early = wrong.  They’ve recognized the unsustainable pace of the advance, and they know they stand to benefit big if they can simply time their entry well.  Unfortunately, their confidence is battered at this point, as is their account.  They’re wounded but staying attentive for an opportunity which will quickly increase their boldness.

-regrets, regrets, regrets.  Repetitive questions of “why didn’t I sell back at $__” plague this crowd, and they’re absolutely sick of getting beaten up.  They’re throwing in the towel, and planning to buy a small used boat with what’s leftover.  It’s been a long road for them, but the pain isn’t over because as the low gets established and price rebounds without them, their ego takes one last significant hit.

Buyers – what began as a bold get-in-front-of-the-freight-train move has chipped quickly away at their equity as time after time new lows stop them out.  But with some dry powder still available, they sense a chance to pick up some bargains with potential.  If they can only endure the foul smell of a sick market and go completely against the crowd, it’ll pay off big so they hang around and keep trying until their ship comes in.

The Biggest Question

Are you in the habit of evaluating not only the conditions you’re trading in, but also the participants at any given point in time?   Understanding what the flip side is thinking will help keep you grounded and more aware of whether it’s time to hold ’em or fold ’em!

Thanks for stopping by and I’ll see you here soon with more. Until then…

Trade Like a Bandit!

Jeff White

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