Stop Worrying About an Overbought Market Do This

While there are no sure things in the stock market, there is one thing that's almost certain: After stocks go up, bears start calling for a correction.

You might remember the bears warning in April 2009 (shortly after the market bottomed) that the rise in stocks was a bear market rally and new lows were inevitable. The S&P 500 had jumped more than 15% in three weeks at that time and was overbought... according to the bears. Yet, stocks continued higher from there, embarking on a seven-year bull run.

Fast-forward to present day, and after the S&P 500 shot up 5.5% in less than a month's time, the bears are once again calling the market overbought.

Stocks being overbought means prices have gone up too far, too fast. There's no precise definition of "too far, too fast," but many analysts use indicators like the stochastics oscillator shown at the bottom of the SPDR S&P 500 ETF (NYSE: SPY) chart.

SPY Chart

When the market becomes overbought, a pullback is expected. That's the theory anyway, but the chart shows why it doesn't really matter if the market is "overbought."

Beginning in 2012, stochastics showed SPY was overbought for 42 consecutive months. During that time, the ETF gained almost 50%.

SPY is once again overbought according to stochastics, but that tells us nothing about what to expect next. The market's current trend is up and will be until it turns bearish.

The chart below shows SPY with a 10-month moving average (MA). When prices are above the MA, we are in an uptrend. A downtrend is defined as times when prices are below the MA.

SPY Chart

This is a simple technique, but in the long run, following the 10-month MA allows investors to capture most of the upside of a bull market while avoiding most of the downside of a bear market.

For now, this strategy is telling investors to ignore the calls for a bear market and enjoy the bull market. 

But What If We are Headed for a Correction?

Even though we are currently in an uptrend, it can be daunting to buy stocks when there are rumblings of a correction.

In times like these, I am reminded of something one my mentors, Ralph Acampora, said. Ralph was often seen on Louis Rukeyser's "Wall Street Week," which ran on PBS every Friday night from 1970 through the early 2000s. Ralph is also one of the founders of the Market Technicians Association (MTA), a professional organization I belong to.

Ralph explained to me why he doesn't worry about the short term by asking, "If you knew that a 10% correction was coming, would you sell a stock at $20 to buy it back at $18?"

The answer for almost everyone should be, "No, I wouldn't sell at $20 and buy back at $18." There are costs associated with doing that -- commissions, slippage on the two trades and possibly taxes. After expenses, the amount saved will be less than 10%, and although this trade would sidestep a correction, it carries a great deal of risk. 

If the correction doesn't come, you would miss out on the upside. If the correction does come, would you actually buy the stock back at $18, or would you wait for an even better price? The risk of waiting is that the market could turn up and you would miss out on the gains. 

Ralph's advice was simple: Ignore the small changes in the market and focus on your long-term strategy. It's this mindset that allowed Ralph to enjoy a successful 50-year career in the market, and it's advice that's helped me build a 96% win rate since 2013, closing 134 winning trades out of a total 140.

I achieved this win rate by selling put options on high-quality stocks. And before you throw in the towel and say, "Nope, not for me," I want to tell you that one of my Income Trader subscribers -- Brad C. from Memphis, Tennessee -- wrote to tell me he made more than $1 million following my put selling recommendations. 

Selling puts can be an incredibly lucrative strategy -- when done properly -- and is likely less complicated than you think.

To show you what I mean, I want to walk through a recent recommendation, which could wind up yielding an annualized return of 80%.

On Nov. 28, I issued a trade on Seagate Technology (NASDAQ: STX), which was trading at $39.10, as my research showed it offered an attractive combination of growth and value. Specifically, I recommended readers sell puts options with a strike price of $36 that expire on Dec. 16. 

Selling a put option obligates the option seller to purchase shares of the stock from the option buyer at the strike price if they are below that level when the option expires. In return for accepting this obligation, the seller collects an instant income payment, known as a premium.

From this point on, one of two things can happen:

If the stock is below the strike price at expiration, the put seller will purchase the shares at the option's strike price. Remember, this is a long-term-oriented strategy, so I only sell put options on stocks I want to own anyway at a strike price I find attractive. In this scenario, I take ownership of the shares at a discount.

While I'm happy to pick up good stocks at a discount, I usually end up with a different outcome. The vast majority of the time, when expiration rolls around the stock is trading above the strike price of the put I selected and the income earned is pocketed with no further obligation.

Let's get back to the STX trade. 

Selling one STX Dec 36 Put generated immediate income of $30. This put obligates us to buy 100 shares of STX at $36 a share if the stock trades for less than that on Dec. 16, the last day these options can be traded.

Since there is a chance we may have to buy shares, and buying 100 shares of STX at $36 each would cost $3,600, a typical broker will require a margin deposit of $720, which is 20% of the purchase price. If the put expires worthless, the $30 in income represents a 4.2% return over the margin deposit. 

Since this trade will only be open for 19 days, that works out to an annualized return on investment of 80%.

With returns like this, I don't plan to lose any sleep worrying about when the next correction will hit. Instead, I'll spend my time searching for more trades like this.

If you're interested in getting my next recommendation or learning more about how I pick the right put options, follow this link.

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