You’ve undoubtedly noticed stock markets have been selling off since the beginning of the year. Many traders are deciding what to do about that, and you’re likely included among them.
A popular strategy will be to panic and overreact. Traders will see their gains become much smaller, or even turn into losses, and feel they need to secure their capital before things get worse. This emotional response triggers more selling, which instills panic in more traders.
If markets keep going down, sellers feel like geniuses. But eventually, sellers face a challenge. They need to get back in…
This is often when a different kind of panic sets in. Traders become so afraid that the decline will continue, they often freeze and wind up holding cash for years.
Another popular strategy is to hunt for bargains. This is a popular idea because it’s easy to do emotionally.
Traders look at a stock that’s down by 50% and assume the old price was correct, and what they’re seeing now is temporary.
So they buy, expecting the stock to double. Sometimes that happens. More often than not, the depressed price is closer to the correct valuation.
I prefer to take emotion out of the trading process. This is a highly difficult method of trading the markets, but it’s essential.
So when I see a sell-off, I don’t panic-sell or start hunting for “bargains.” Instead, I implement a mean reversion strategy.
Mean reversion strategies are based on the idea that stocks that have suffered steep sell-offs are likely to bounce back in the short run. It’s a strategy that actually benefits from bargain hunters.
The difference is there’s no commitment. Instead of expecting the stock to double and waiting for that, mean reversion strategies look for small, quick gains.
Mean Reversion in Action
Take yesterday’s market action. Stocks opened low, fell even lower, and then bounced all the way back by the end of the day. Mean reversion traders likely started buying when the S&P 500 became oversold in the short term.
While this strategy can work well with stocks, when it doesn’t work the losses can be very large.
That’s because it’s possible a company announced bad news and traders are selling in response to that, and not just broad market conditions. In some cases, the news is so bad that the stock will continue lower for months even if the market recovers.
To avoid this risk, I like to apply mean reversion strategies to exchange-traded funds (ETFs). Since ETFs hold many different stocks, their risk is spread out and they aren’t subject to the same amount of risk as individual companies.
For example, I tested this strategy using the 100 ETFs I track in my newest trading strategy, which we’ll release to the public in the coming months: Market Leaders.
Over the past year, buying the most beaten-down ETF every week and holding for 1 week resulted in a gain of 52.2%, roughly double the S&P 500’s performance.
However, I should note that the maximum drawdown of this strategy, an important measure of risk, was almost 15%. That’s roughly double the largest drawdown of 6% seen in the S&P 500 over the past year. In other words, you’re taking a bit more risk to more than double the S&P 500’s performance. This just comes with the territory — it’s the price you pay for market-beating returns.
The simplest strategy to deploy during sell-offs is to just buy the ETFs that are down the most in the past week. The sponsor of the Select Sector SPDRs maintains a useful website that shows different measures of performance.
You can click on the 5-day performance and see which ETFs have fared the worst. We can see that Consumer Discretionary (XLV) and Tech (XLK) are the worst performers over the past five days. So with a mean reversion strategy, you could buy these. Then, selling a week or a month later is a potential exit strategy.
Another useful feature of ETFs is that they’re almost always optionable, and options are a potentially even more profitable method of trading this strategy.
Buying an at-the-money call option on the worst-performing ETF over the last 5 days, dated out several weeks or a month should give you enough time premium to profit.
Michael Carr, CMT, CFTe
Editor, One Trade
Chart of the Day:
The Moment Mean Reversion
Traders Showed Up
Today I want to zoom in a bit more than usual on the SPY chart, with the 15-minute candles.
Yesterday’s sell-off was aggressive, to say the least. Stocks opened down nearly 1% and fell as low as 2% just an hour later.
But that’s when the mean reversion traders showed up.
You can almost see the moment. The RSI went deep into oversold territory, more oversold than the shellacking the market got to close out last week. At the same time, the blue MACD line started to climb upward, eventually meeting the orange signal line.
When it crossed, the RSI was back into its neutral zone. That powered a rally that ultimately took the S&P higher than where it opened.
I don’t tend to check these super short-term timeframes too often, but they’re useful for traders who want to scalp the market for gains every other hour. If that’s the type of trader you are, watch for oversold conditions on the momentum indicators, as well as crosses on the 9-EMA, 20-EMA, and 50-SMA with these shorter periods.
If the market opens strong today, we could easily see a bullish cross on the moving averages. That would be the sign for technical traders that the short-term bottom is in.
Managing Editor, True Options Masters