Stocks are definitely overbought. Overbought markets occur when prices move up sharply, and based on current charts, prices appear to be too high.
Prices might be irrational, but as traders, we need to remember that the fact that behavior is irrational 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 ETF (NYSEARCA: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.
SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) is being used because it reflects the price changes in the Dow, which 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, SPDR Dow Jones Industrial Average ETF (NYSEARCA: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, six to 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 is that deep in-the-money calls are more likely to be profitable at expiration.