How to Respond to Price Extremes - dummies

How to Respond to Price Extremes

When a price has reached or surpassed a normal limit defined by an indicator, that price is at an extreme. Extremes can be either up or down:

  • In an up move: Everyone who wanted to buy has already bought. In this case, you can say that the market is overbought, a term specific to securities trading.

  • In a down move: Everyone who wanted to sell has already sold; the security is called oversold.

Technical traders apply the concepts of overbought and oversold to market indices, as well as individual securities. The terms overbought and oversold are applied to the security, but what the terms secretly refer to is how much money the traders in that security have available at the moment. By the time most of the market participants have jumped on the bandwagon, the wagon has become so heavy it can’t move forward. Traders are tapped out. All their money is in a position. Traders have to get out of their positions just to put cash back into their pockets so they can conduct additional trades.

Position squaring is the closing of positions after a big price move. Position squaring doesn’t necessarily imply that market participants think a move is over. They may plan to reenter the security in the same direction later on.

Position squaring occurs for many reasons, including the following:

  • Traders think that the move is exhausted for the moment.

  • Traders have met a price objective — whether profit or loss.

  • Traders have met a time limit, such as the end of the day, week, month, or tax period.

  • Traders want to withdraw money from the security to trade a different security, or for a non-trading purpose.

Position squaring occurs when a large number of traders have big losses, too. Say, for example, a high percentage of traders believe in a particular price-move scenario that then fails to develop in the expected way. Eventually, a few traders throw in the towel. The resulting change in prices causes bigger losses for the remaining traders, and they, in turn, give up. You get a succession of stop-loss orders being hit that turns into a down-market rout, or even a panic. (A stop-loss order is an order you give to your broker to sell your position if it goes against you too far and reaches the maximum loss you’re prepared to accept.)