Overbought conditions and $TZA, $MMTW, $MMFI

We are approaching very overbought conditions, with extended readings in major indexes and individual names. Despite this, however, there aren’t clear signs of a serious selloff coming. The gradual loss of momentum might indicate that the correction is not to far away, but its intensity may be moderate since bulls have shown impressive strength and dip-buyers may just be waiting for good entry points.   The percentage of stocks above their 20 day and 50 day average are approaching 80% and 85% respectively. This indicator has proven quite reliable in anticipating the reversal.

The figure below shows the values of $MMFI (stocks above their 50 day average) and $MMTW (stocks above their 20 day average) with respect to a $TZA short play. The $TZA buy signal is given by the stochastic reversal in both $MMTW and $MMFI. The return of this strategy has been mixed, with nice gains going into the volatile summer of 2011 and more moderate gains in periods of lower volatility.

As always, trying to pick the top is not the most rewarding strategy, especially with decaying etfs ($TZA was at $40 back in December 2011). Shorting $TNA might be a lower risk play. Profit taking stops are mandatory anyway. Such general overbought conditions however are quite rare, and combining $TZA with $MMTW and $MMFI might be an effective way for timing  the correction.

Charts curtesy of Barchart.com

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