My favorite thing to trade is the S&P 500 because it’s “pure.”
That makes it simpler to trade.
The core of my trading strategy is that everything eventually reverts back to the mean.
That’s why I like trading the S&P 500. Compared to individual stocks, it’s easier to tell whether the S&P will rise or fall throughout the day – and when a move up or down gets overextended.
With individual stocks, you have to deal with a lot more noise. That can work to your benefit with research and a deep understanding of the stock, of course.
But if you don’t have that deep knowledge, you might assume a stock will go up along with the market.
But a rising tide doesn’t necessarily lift all boats.
The reason could be the company released bad news… There could be a big seller… Or it could be a bevy of other things. But individual stocks are less likely to follow a trend like the indices do.
And my mean reversion strategy with the S&P 500 helps me to win more often than I lose.
It’s simple. What goes up must come down…
Reverting to the Mean
The primary thing I look for is a two- or three-day mean reversion. That means if the market has two or three days up, it’ll likely head back down to the mean soon.
(With stocks, I often extend my time frame closer to five days because computer algorithms have really messed with the natural trade flow of the markets.)
Think of it like a rubber band… The further it stretches, the more it wants to snap back to neutral.
So if the S&P 500 jumps up for several days, I’d look to short the market in anticipation of a pullback. It works the opposite way, too.
The market tends to have a bias to the buy side, but everything comes back to the mean eventually.
And the longer things stray outside the mean and get more and more overextended, the stronger the move back to the center.
Of course, this rule is not 100% accurate… because the market isn’t logical. Just because something is overextended doesn’t necessarily mean it’s going to revert.
That’s why you have to be able to spot signs that the reversion will take place.
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Spotting the Signs
To me, that comes from watching technical indicators, particularly the Relative Strength Index (RSI).
The RSI gauges momentum. Momentum lets me see whether a stock is overbought or oversold.
If buyers push too hard, the resulting rally will inevitably invite sellers to take profits. That’s why you see pullbacks even in the strongest rallies – it’s simply too tempting for some investors not to sell at highs.
It’s a similar story with an oversold market. If sellers panic and dump their stock, the price dip will likely bring in buyers looking for a bargain. In the short term, this can drive a stock price higher.
When either happens – causing a change in momentum – the RSI can provide clues about when to enter or exit a trade prior to a reversion.
And when a mean reversion does happen, you need to be ready to act. It could be as little as half of a percent or as much as 2%.
But depending on how you trade it, you can make much more than that – especially using options.
This month, I’ve shared a couple of recent examples of how we’ve profited from this strategy with a quick 27% win in The Opportunistic Trader… and a 23.5% gain in less than 24 hours in One Ticker Trader.
By doing that over and over again – and accumulating profits, big or small, on those moves – you’re putting a “P” (profit) on the page.
And as I’ve said countless times before, that should be the No. 1 objective of every single trader out there.
Have a great Thanksgiving weekend.
Editor, Trading With Larry Benedict