Trading This Reversal Gave Us a 27% Win

With a whopping 14.1% gain last October, the Dow Jones booked its best monthly performance in 47 years.

The Nasdaq and S&P 500 only recorded 4% and 8% gains, respectively, over that same time.

The huge difference in performance represented a fundamental change in the market – a rotation out of big tech and into old-fashioned, large-cap value stocks.

Like any change in money flow, though, this rotation can get out of whack. The Dow is vulnerable if its constituent stocks get bid up too far.

Likewise, if the spread between the SPDR Dow Jones Industrial Average ETF Trust (DIA) and Nasdaq or S&P 500 stretches too far, then that spread can also reverse back the other way.

So today, I’d like to show how we used those factors last year to catch that reversal in my options advisory, The Opportunistic Trader.

That trade generated a quick 27% return in just four trading days. So, let’s examine how that trade played out…

The Power of Mean Reversion

On the DIA chart below, the 50-day moving average (MA – blue line) represented DIA’s long-term trend.

The 10-day MA (red line) showed the countermoves within the overall trend.

Take a look…

SPDR Dow Jones Industrial Average ETF Trust (DIA)

Source: eSignal

Mean reversion trades aim to profit from reversals… when an asset turns around and goes back the other way.

Think of it like a rubber band stretching and then snapping back. DIA did this back in mid-August.

As you can see, DIA peaked when the Relative Strength Index (RSI) formed an inverse ‘V’ (red circle) in overbought territory (upper grey dashed line).

Then, as the RSI began to track lower, DIA’s share price fell.

We planned to profit from a similar pattern repeating when the RSI again went into overbought territory in late October (second red circle).

With the RSI again forming an inverse ‘V’ at overbought territory, we bought a put option on DIA on October 28. (Note that a put option’s value increases when a stock price falls.)

When buying momentum reverses (as the RSI shows), it’s only a matter of time before the share price retreats too.

Take another look at the DIA chart…

SPDR Dow Jones Industrial Average ETF Trust (DIA)

Source: eSignal

In this case, although DIA traded slightly higher over the next few days after we entered the put trade, the reversal in the RSI eventually led the price to fall.

This enabled us to exit our position by selling our put option on November 3 for a 26.7% gain.

Amplifying Our Gains

That was a decent return in just four trading days, but it wasn’t the only reason we sold…

Typically, price reactions revert after Fed meetings.

The markets had sold off the previous day following the Fed’s 75-basis point rate increase. So we wanted to avoid leaving profits on the table if DIA counter-rallied.

Especially in a volatile market, it’s smart to take quick gains off the table.

And to be clear, we made this profit using options, which enabled us to amplify our gains compared to using shares. That’s why we focus on options in my trading services.

So with just a 3-4% reversal in DIA, we picked up a nearly 27% gain.

Ultimately, by being nimble and capturing quick reversals, we can pick up tidy profits even from small underlying moves.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

P.S. If you’re interested in exploring options, my One Ticker Trader advisory is a great place to start. There, we focus on one single trading idea each month.

And by adding up small gains over time, we’ve generated a cumulative 213% return on our cash since we launched last August.

To learn more about how we’ve been winning – even in this volatile market – go right here to watch my recent interview.

Reader Mailbag

In today’s mailbag, readers give thanks to Larry for sharing his trading expertise…

Great trading and simple philosophy, it really helps. It needs to be repeated and repeated. Thanks so much. I loved our seven rules.

– Carmen N.

Hello Larry,

I’ve been reading your emails for a while, and I’m impressed enough to have signed on for all the services you offer on a lifetime basis. I’ve been trading options for over 10 years, and I normally don’t subscribe to newsletter services.

But your background and insights impressed me sufficiently to trust your judgement regarding my investments. While your services collectively were not inexpensive, I do believe that I will make ten-fold that amount soon enough.

Thank you for all the hard work you do for your clients, and I look forward to a very lucrative association with you.

– PK S.

I just want to tell you how impressed I am with your website and trading style. I’ve subscribed to many stock trading sites over the years, and I currently follow four such sites.

I currently work a four-day week which has not been very financially rewarding lately, so it’s my hope that following your trades will supplement the income missing from my full-time job as well as eventually replacing it.

I’m looking forward to growing my account in 2023!

– Robert D.

Thank you, as always, for your thoughtful comments. We look forward to reading them every day at [email protected].