I received this question from one of our readers earlier this week:

Hi Adam,

Hi AZ,

The short answer to this is, there is no short answer. Personally, I have a set of conditions that are basically pre-conditions to being able to take a countertrend trade–I use these in my own trading and teach them to the traders I mentor, but what matters is that you have a condition or a set of conditions that make sense to you. Furthermore, that condition must have a real, verifiable edge. Never use any technical tool on faith, without thoroughly investigating how it performs under all market conditions. As a bare minimum, I would want to see a new tool applied to maybe five years of intraday bars on 20 stocks, and would also want to see it on other time frames and on forex, futures, individual stocks and indexes. I would want to look at the tool with objective statistical techniques, but would also want to spend an equal amount of time using it in more subjective, discretionary ways. I would also specifically isolate some crazy, extreme market environments (think crash of 1987, or the recent flash crash), and see how the tool would have fared in those conditions. Basically, I want to stretch the tool as far as possible and learn everything about it. If you aren’t doing this kind of work and are just punching up some out-of-the-box oscillator without really knowing how it works, or, even worse, are changing between tools all the time, I don’t think you’re likely to have much luck. With that out of the way, let me share some general thoughts:

One of the common ways this is done is to use an oscillator or something to quantify an overbought or oversold condition. This is not something I would use, because markets go overbought in strong trends and stay overbought while they trend much further than anyone thought possible. Traders fading because an oscillator says “overbought” have to endure a lot of pain. This is probably the most common tool in general use, and I just wanted to put it up front here that I have never really been able to make this work. Here are some ideas that I think do have value, in kind of stream of consciousness format.

• There is some value in very short-term oscillators (think of something like a 2 or 3 period RSI), especially on daily time frames. I have found less use for these intraday, and I suspect the reason is that they capture the overnight Taylor rhythm. If you are interested in semi-automated systems trading, it’s probably worth your time to look at these very short-term oscillators if you haven’t already.
• I actually do think there are some good uses for momentum oscillators that will point out momentum divergences (in all timeframes). We don’t focus on too much on this on the trading desk, but if you are already using something like a MACD, you can trade overextended markets on momentum divergences. Again, there is no quick fix here as it takes long study to learn how to use these tools well.
• The key idea for all forms of overextension is that a market is doing something that is not normal or outside of normal parameters. In this regard, looking at how far the market is from a moving average might be a useful crutch. There are also a number of bands (Bollinger, Keltner, simple percentage bands) that may be useful.
• There are also a handful of chart patterns that can help.
• With a lot of experience, traders can get a feel for when a market is “parabolic” or very overextended. Until you develop that sense, some of the tools above may help shorten the learning curve.

I wish I could provide a simple answer to this question, but it’s just not possible. Any tool you use will require a serious commitment of time and energy. As a last thought, if you are correctly identifying overextended markets, you should get fairly immediate gratification on your time frame. For instance, if you are a daytrader, you probably should not have to wait several days to be proven right if you’re fading an overextended market. There is a fine line between “overextended” and “just really strong”, so good stops and excellent discipline are necessary–otherwise you will find yourself in the position of simply fading a very strong market, enduring a ton of pain, adding to losing positions and hoping to get back to breakeven on the trade if you’re lucky. That’s no fun at all and certainly not a way to build a trading career.

Follow me on Twitter (AdamG_SMB)–I’ll try to point out some overextended points this week.