Most of the time, short term bullishness and short term over-heating can be confusing, and inexperienced investors would sell their positions too early and as a result, missing the big trend.
Short term indicator: Stochastic.
Stochastic is an important short term indicator for it is sensitive to detect price swing within a short time frame. Therefore, to determine the short term movement of a stock price, understanding the Stochastic is a must for serious investors. Generally, when the Stochastic should start rising and break above 30% level, it is a signal suggesting that the short term movement of a stock price is beginning to improve. If the Stochastic should continue to rise and break above 70% level, it would be a signal suggesting a short term bullish movement of the stock price. Provided that the Stochastic is still above 70% level, the short term bullish movement is expected to continue. If the Stochastic should break above 90% level, it is a signal suggesting the stock price is getting over-bought, thus some profit taking activities might take place. Some times, the Stochastic might hit 100%, which is a signal suggesting an extreme over-bought signal, thus a higher chance of a technical correction in the near term.
Since the Stochastic is a short term signal, it reflects the short term movement of the stock price. For example, when the Stochastic hits 100%, it suggests a technical correction might take place, and, some times, if the technical correction takes place but only for a short movement, (1 or 2 days) with the Stochastic falling but still above the 70% level, this suggests that the short term movement of the stock price is still bullish. In other words, short term over-bought is actually a sign, a characteristic of a bullish trend.
From a technical point of view, the best technical correction would be a low-fluctuated sideways movement. This is because when stock price is moving sideways, investors will be suffer huge losses, thus the selling pressure is generally mild. With the Stochastic still above 70% level after the technical correction, then chances for the uptrend to resume is usually higher.
(Chart 1) Lionind [4235] from 5/3/08 to 10/6/08.
| Indication: | Description: |
| A | The Stochastic break above 30% level, stock price begin rising. After rising for 6 days, (gaining RM0.44 or 31.4%). When the Stochastic break above 90%, it is a signal suggesting a short term over-bought condition, thus a risk of a technical correction. Later, stock price of Lionind consolidated but the Stochastic remained above the 70% level, therefore, the short term movement is still bullish biased, and coupled with the support of the 14, 21, 31 EMA (as trailing stop level), the uptrend remains intact. |
| B | After a consolidation, price of Lionind rallied again, gaining RM0.59 of 32.6%. This time, the Stochastic is signaling an over-bought condition again; then, the price of Lionind retreated but still supported by the 14, 21, 31 EMA dynamic support, therefore, the uptrend is not violated. Generally, in this case, investors could consider to take profit of 1/3 of their positions. |
| C | The Stochastic hit 100%, but the stock price did not retreat, but continue rising instead. This is a classic example of very bullish movement, as more new buying interests flow in, suggesting the market was indeed very robust. However, despite the strong bullish movement, adding up or buying during a short term over-bought condition is still risky. |
| D | The Stochastic breaks below 70% level, suggesting an end to the short term bullish movement, or the uptrend might come to an end. Meanwhile, the stock price also started falling, but still supported by the 14, 21, 31 EMA. Despite the support at 14, 21, 31 EMA, price of Lionind consolidated again, but the Stochastic has already broken below 70%, suggesting an end to the short term bullish movement, and therefore, a signal to take profit. |
Short term over-bought is not an end of the uptrend:
As shown on chart 1, investors should incorporate the use of Stochastic over-bought signal with the uptrend, therefore, this will avoid over-reacting by selling your position too early, and as a result, missing the big up trend. During a strong uptrend, short term over-bought is, in fact, its characteristic, and price may correct or consolidation afterwards, and some times, price may rally instead.
Most of the time, investors who sold their position during a over-bought condition and later found out that price did not retreat but only move sideways, while the Stochastic is still above 70%. If price should continue its uptrend and rally again, often the investors who has sold their position find it hard to buy again, for they will have to buy again with a price level higher than the price they took profit, as a result, they will miss the second chance of the uptrend.
Topping up during short term -over-bought?
Although short term over-bought signal might not be a time to take profit, it is definitely not a good time to enter or top up positions, because the chance of a technical correction is still high. During some extreme circumstances, like a sudden spike of price, or when the stock price is too far above the 14, 21, 31 EMA of any other trailing stop reference, investors who wish to secure some profit or reduce their trading risk could consider selling part of their position, usually 1/3 of them, while waiting for a technical correction, and they could buy back again when price rebound and resume the uptrend.
Some stock that are currently over-bought:
| Short Name | Code | Condition: |
| Lioncor | 3581 | Mid term uptrend, short term over-bought (Over heated) |
| Tenaga | 5347 | Breakout of Triangle, short term uptrend. (Over heated) |
| Ytlpowr | 6742 | Mid term uptrend, short term over-bought (Over heated) |
| Proton | 5304 | Mid term uptrend, short term over-bought (Over heated) |
| Liondiv | 2887 | Mid term uptrend, short term over-bought (Over heated) |
| Supermx | 7106 | Mid term uptrend, short term over-bought (Over heated) |
| Suncity | 6289 | Mid term uptrend, short term over-bought (Over heated) |
| Gtronic | 7022 | Short term uptrend (Over heated) |
| Gplus | 2968 | Technical rebound, short term over-bought. |
Table 1: Some stocks currently at over-bought condition with Stochastic above 90%. However, these stocks are having their Stochastic above 70%, which is a short term bullish signal. If the Stochastic should break below 70% level, it may be a signal for investors to consider to take profit.
Chart 2: KLCI chart from 24/12/2008 to 24/04/2009
Chart 2 is another example of Stochastic breaking above 30% level, followed by the Stochastic breaking above 70% level (indicated by arrow B), entering the short term bullish region. Although the Stochastic has broken above 90% level many times, the uptrend remains intact due to strong buying interest. Provided that the Stochastic is still above 70% level, the uptrend is expected to continue.
Conclusion:
Continuous short term over-bought is a typical characteristic of a bullish market or a strong uptrend. When an individual stock is over-bought, investors must also study the broad market condition, and the uptrend of that particular stock, before over-reacting by selling their position too quickly. As long as the uptrend remains intact, while the broad market is still bullish, investors should remain calm while study the consolidation of the individual stock.
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