Many traders know the old saw “overbought can become more overbought.” Strongly trending markets may look ready to crack on paper but keep going longer than anyone expects. The other side of that coin is that steep rallies can have equally steep corrections, and they, too, can last longer than anyone expects.

#-ad_banner-#Right now, the energy sector seems to be at a crossroads between these two possibilities. After a sharp run up this year, the Energy Select Sector SPDR ETF (NYSE: XLE) became very extended to the upside by numerous metrics.

Momentum indicators such as the Relative Strength Index (RSI), the spread to key moving averages, lopsided bullish sentiment and an uncharacteristically high price/earnings (P/E) ratio all suggest it is time for a correction.

The question now is how to play it. Do we buy this dip or do we wait for a pullback to a lower-risk entry point?  

For me, after the energy sector has racked up 20%-plus gains since February, the latter is far more palatable. I may miss the next leg higher, but given that the market is still overbought, controlling risk is paramount.

On the daily chart, we can quickly see that prices lifted off the trendline drawn from February’s low and are also far above the 50-day moving average. 

With the RSI indicator at an extreme overbought level, the ferocity and volume of Tuesday’s decline should not have been a surprise. Trading over the past few days left a flag-like pattern, and that suggests the bears are just resting. In other words, there may be another leg to go in this correction before it is safe to buy again.

To be sure, the ETF is still above its shorter-term averages such as the 10-day, and that means the overall trend is still up. So we must decide whether if it is safe to get into this ETF in the short term or wait for something better. 

Some may argue that if the major trend is still up, and the underlying commodity — crude oil — recently had a major upside breakout, then the recent dip has already reduced the risk of buying. I will argue that the weekly chart shown below is as overbought as it has been in more than three years. 

One look at the long-term trendline from 2011 shows a market that could have gotten very far ahead of itself. The slope of the rally this year is exceptionally steep relative to the past few years. 

For me, waiting for the second half of the current pullback is a better option than jumping on this dip. Entry at the February trendline in the $98 area, where we have the benefit of solid support features such as the trendline and the 50-day moving average, reduces risk, especially in setting a stop. A breakdown below the trendline would result in a small loss, while the upside potential is a breakout to a new high and beyond. 

The percentages here are not large, especially when the momentum names of the day make double-digit percentage moves every week. But sometimes lower expectations are better, especially when events in Iraq, the 800-pound gorilla in the energy market, are still fluid.

Action to Take –>

— Buy XLE on a pullback to $98
— Set stop-loss at $96
— Set initial price target at $103 for a potential 5% gain in three weeks

This article originally appeared on ProfitableTrading.com:
​Is it a Good Idea to Buy Energy Here? The Charts Say…

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