T2108 Update – January 20, 2012 (Tentative Rules for Trading Overbought Periods)

(T2108 measures the percentage of stocks trading above their respective 40-day moving averages [DMAs]. To learn more about it, see my T2108 Resource Page. You can follow real-time T2108 commentary on twitter using the #T2108 hashtag. T2108-related trades and other trades are posted on twitter using the #120trade hashtag)

T2108 Status: 84% (overbought day #13)
VIX Status: 18.3
General (Short-term) Trading Call: Close more bullish positions, begin/expand bearish positions

Reference Charts (click for view of last 6 months from Stockcharts.com):
S&P 500 or SPY
SDS (ProShares UltraShort S&P500)
U.S. Dollar Index (volatility index)
VIX (volatility index)
VXX (iPath S&P 500 VIX Short-Term Futures ETN)
EWG (iShares MSCI Germany Index Fund)


T2108 closed for a 13th straight day in overbought territory. At 84%, T2108 is at 2-month highs. Even as this overbought period drags on, it is easy to forget that just two months ago, T2108 remained overbought for 18 straight trading days. It ended with almost no net gain for the S&P 500. Subsequently, a 6-day rapid slide to November lows. The huge difference then is that the resistance that provided a brick wall for the market was very clear at the 200DMA. Today, the S&P 500 is still rising in a breakout formation above the 200DMA. Only the July highs (3% away) and the 3-year highs (4% away) stand in the way of the current run. Because of the drip-drip nature of the rally, I have still not implemented a 100% bearish T2108 position, but clearly, I should move to 100% soon. I went from 50% to 75% on January 19th.

The VIX is getting more interesting. It plunged an astounding 7.5% to 18.3. The August swoon is completely history now. The increasing complacency marked by the sharp decline in volatility supports the assumption that this overbought period is now fraught with risks. It also means that a negative catalyst could generate an extremely sharp pullback. However, given the current rise, one must assume the 200DMA will provide relatively firm support. Note well, a 4% drop takes the S&P 500 back to the 200DMA. If the stock market is actually in the beginning stages of a major bull market run, then the balance of risks are exactly even here. Of course, if this move is another major fake-out, then the balance of risks are firmly to the downside.

The change in conditions from November to today reminds us that T2108 trading is short-term in nature. Going short in the last overbought period worked out extremely well, but for a limited time. Traders had to define an exit condition (I covered within the first few days because I still had a bullish bias based on the strength of the bounce from the October lows).

These points present multiple challenges to T2108 trading that are similar to the challenges I discussed in the throes of the August swoon when it seemed crazy to look for entry points for bullish positions. If a trader thinks the S&P 500 is in the early stages of a massive bull market run, bearish T2108 positions need to be closed quickly into the next pullback. A stop loss must be defined. If a trader is agnostic/neutral then a small position-size allows one to remain patient enough to allow the overbought period play out (this is currently my camp). In an earlier post I discussed buying out of the money calls as a potential hedge to facilitate patience. Anyone following my tweets knows I am also making use of this time to take advantage of some of the market’s current tendency to drive tremendous upside in speculative and beaten up stocks. These opportunities seem to abound during long overbought periods (something I eventually hope to study in more detail – it could develop into an ancillary trading rule!).

Finally, If a trader is extremely bearish, it is actually even MORE imperative that a stop-loss gets defined because someone who is extremely bearish here will be prone to clinging to this thesis even as drawdowns balloon.

One’s bias will also determine next steps after the bearish position is closed out. For example, even after closing out my bearish positions in November’s pullback, I waited for T2108 to drop to oversold levels (20% or below) before restarting T2108 bullish positions. Unfortunately, the market jumped ahead of “schedule.” T2108 has little to say about trading stock market movements between the extremes. If the market gains fundamental, underlying strength, I will have to seriously consider redefining what extreme means for the given context (recall that from the March, 2009 lows until 2010, T2108 never dropped much past 30% on pullbacks). Note well that such dynamism in T2108 trading will break new ground and will require me to apply additional analysis to generate simple, executable rules.

In the meantime, consider these musings the beginnings of rules for trading overbought periods. I expect in due time to have simple-to-follow rules similar to those I have established for oversold periods. The bottom-line for now is to exercise proper risk management including sizing positions appropriately for your risk tolerances.

I am always interested in hearing your thoughts on approaches and analysis!

Charts below are the latest snapshots of T2108 (and the S&P 500)
Refresh browser if the charts are the same as the last T2108 update.

Daily T2108 vs the S&P 500
T2108 vs. the S&P 500 (DAILY)

Black line: T2108 (measured on the right); Green line: S&P 500 (for comparative purposes)

Weekly T2108
Weekly T2108
*All charts created using
freestockcharts.com unless otherwise stated

Related links:
The T2108 Resource Page
Expanded daily chart of T2108 versus the S&P 500
Expanded weekly chart of T2108

Be careful out there!

Full disclosure: long SDS; long VXX

2 thoughts on “T2108 Update – January 20, 2012 (Tentative Rules for Trading Overbought Periods)

  1. Thank you for your kind response to my previous post. I failed to mention that I also have a reasonably large position in Mar-12 VXX 20 puts that I averaged in at 0.09/shr and are now around 0.18. The VIX futures are trading in contango as volatility in the near-term has come off and that has led me to a new trade idea that I’m modeling:
    SPY Feb-12 strangle: 133C/130P to take advantage the relatively low vols paired with a short Mar-12 SPY call spread at ~137/143. I’d sell the number of contracts required to make the call side net delta neutral, which currently is short 11.5 to long 5 133 calls. If SPY moves up, I’d roll the spread initially up with more contracts and then out, if necessary. I’d roll the 133 calls up to take profits and maintain coverage on call side. In (what I consider to be) the more likely scenario that the market trades down and volatility increases, the position would perform well. I would look to exit by the end of this week.

    Your thoughts?


    Jeff Jage

  2. Wow. That’s pretty complicated for a trade you want to close out in 4 days! Since the near-term outlook is bearish, you could also sell the Feb call spread but I take it you are hedging a little there. Otherwise, I like this idea. Definitely let me know how it works. You should consider closing out the VXX puts soon since you are expecting volatility to rise (as am I).

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