Larry’s note: Welcome to Trading with Larry Benedict, the brand new free daily eletter, designed and written to help you make sense of today’s markets. I’m glad you can join us.
My name is Larry Benedict. I’ve been trading the markets for over 30 years. I got my start in 1984, working in the Chicago Board Options Exchange. From there, I moved on to manage my own $800 million hedge fund, where I had 20 profitable years in a row.
But these days, rather than just trading for billionaires, I spend a large part of my time helping regular investors make money from the markets. My goal with these essays is to give you insight on the most interesting areas of the market for traders right now. Let’s get right into it…
The first thing I do every day is look at the S&P 500. It helps me to get an idea of the overall market. I can then drill down to the sectors and individual stocks to see how each sector is acting compared to another.
And so, if you watch the S&P 500 as closely as I do, you’ll know one thing for sure… For the last 15 months, it’s been on a tear.
Since April last year, the S&P 500 has nearly doubled.
For an index that contains multiple trillion-dollar stocks like Apple (AAPL), Amazon (AMZN), and Microsoft (MSFT), that is one heck of a move.
But while the traffic has been pretty much one way — in this case, up — there have been many smaller counter-moves (or counter-trends) along the way.
Take a look at the S&P 500 chart below, and you’ll see what I mean.
The blue line represents the 50-day moving average (MA), showing the overall longer-term trend of the S&P 500. In this case, it’s been a steady climb for over a year. The black line represents the price of the index.
You can see the S&P 500 moved lower in September and October last year. And again, in February, March, and May this year.
In fact, the closer you look, the more counter-moves you will see.
That all adds up to something quite clear…
Markets don’t move in straight lines. Not for a day, or even for a week. And certainly not for over a year.
It’s these counter-moves – that go against the bullish trend – that I search out for my trading opportunities. The technical term for this is mean reversion. Put simply, when stock prices move away from their average, I take note of it. And then I trade it.
Let’s take another look at the S&P 500. This time, though, using a shorter timeframe.
The chart below shows the S&P 500 from August through December of last year.
S&P 500 (SPX) — Daily Price Chart
There’s quite a lot going on in this chart, but I’ll explain what it all means.
Like the previous chart, the blue line represents the long-term 50-day MA and the black line represents the price of the index.
This time I added Bollinger Bands (BB). Those are the two red lines you can see on the chart.
Bollinger Bands show how far prices have traded from the average (blue line). The way Bollinger Bands are calculated, 95% of that price range lies within these two red lines.
Because the blue line is an average, the idea is that the stock price (or index level) will eventually revert to the mean (average).
Above (or near) the top red line means the stock or index is overbought. Below (or near) the bottom red line means it is oversold.
On their own, Bollinger Bands are not enough.
As you can see through August, the price reached the upper red line, indicating the index was overbought. Yet the blue line (average) continued to move on up.
That’s why what I do next is crucial.
First, I use the long-term MA to determine the overall trend. This part is key.
Next, I use Bollinger Bands to determine where to enter the trade.
It’s important to put the two together.
If the long-term trend is up, I use the bottom red line as a place to buy. If I get it right and the price reverts to the mean (moves higher), I can then look to sell out for a profit.
For example, the two green circles represent two notable counter-trends in the S&P 500. The index moved much lower than it previously had – coming all the way down (or near) to its lower Bollinger Band. That would’ve been a good place to buy. As you can see, the price continued to move higher both times it fell to the lower BB.
Similarly, if the long-term trend is down, I use the upper red line as a place to go short. In this case, if the price reverts to the mean (moves lower), I will look to buy it back for a profit.
By using Bollinger Bands in conjunction with a long-term average, you can help put the odds in your favor.
And in doing so, you can take advantage of the many counter-moves in the markets.