In the trading universe, you often get to hear from people who claim that a particular market was “overbought” and “oversold” according to their magical indicator, or even gut feeling. Oftentimes this message implies to be cautious with new commitments and expect a lower risk to reward ratio than it used to be at the beginning stage of a trend.
Unfortunately, the inexperienced trader all too often interprets such “oversold” conditions as a signal to buy into a falling market. If you can’t expect to earn much with the current downtrend anymore, the reward must be waiting on the opposite side, must not it?
This is often very important section of this specific subject. Not quite. The general wisdom among trend traders 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 temporarily will henceforth break for new lows because of an underlying bearish force in the market. This indicates that optimistic market participants aren’t going to succeed in the long run. It’s simply the nature of downtrends that buying into them is a very challenging proposition. 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 the daily chart of the S&P five hundred index, for example, and look out for decisive highs created along the way. As long as striking intermediary highs haven’t been taken out by the bulls, the trend is still regarded negative. Buying in a downtrend is a fool’s game.
How can we trade an “oversold” market then? If you’re in a position already, the easiest answer is to evaluate whether a tighter stop-loss makes sense. Set it to the most recent peak that was formed on the way down to protect your profits, and continue to participate in the trend should it resume. This is straightforward and the best defensive tactic I’m using so far. We’ll never know the exact outcome after all, so this approach makes perfect sense.
If you have no position, be on the lookout for promising entry opportunities. You want to make sure that price is smashing through a visible resistance area with momentum. An example would be the break of a small downtrend (bull flag) or an intermediate horizontal resistance level that’s visually striking in the one hour chart.
You shouldn’t jump into the market or close out a good short position in panic just because some random trader shouts “oversold”. 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 a trend.