How to Put the Trading Odds in Your Favor

I get a lot of cues about the market just by reading the tape on the S&P 500…

Which is why it’s the first thing I look at every day.

It helps me get an idea of the overall market. I can then drill down to individual stocks to see how each sector is acting compared to another.

But even just the way a sector moves – accelerates and decelerates – is telling. And if you watch the S&P 500 as closely as I do, you’ll know one thing for sure…

This year, it’s been tumbling downhill.

Since January, the S&P 500 has fallen over 20% into official bear market territory.

Countermoves Mean Plenty of Trading Opportunities

But while the traffic has been pretty much one-way (in this case, down) – there’ve been many smaller countermoves (or countertrends) along the way.

Take a look at the S&P 500 chart below, and you’ll see what I mean…

The orange line represents the 50-day moving average (MA), which shows the overall long-term trend of the S&P 500. And the dark blue line represents the price of the index.

In this case, it’s been a steady slide for almost a year.

But while the S&P 500 moved overall lower this year, we can see a number of countermoves as well.

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 countermoves – that go against the primary 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. But this time, using a shorter timeframe…

Don’t Forget To Use Bollinger Bands

The chart below shows the S&P 500 from March to September…

There’s quite a lot going on in this chart, but I’ll explain what it all means.

Here, the black line represents the long-term 50-day MA and the dark blue line represents the price of the index.

This time I added Bollinger Bands (BB), marked by the two red lines. Bollinger Bands show how far prices have traded from the average (black line).

The way Bollinger Bands are calculated – 95% of that price range lies within these two red lines.

Because the black 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, twice since March, the price reached the upper red line, indicating the index was overbought. Yet the black line (average) continued to move on down.

How To Identify the Right Trade

That’s why what I do next is crucial…

1. First, I use the long-term MA to determine the overall trend. This part is key.

2. 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.

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.

For example, the two green circles represent two notable countertrends in the S&P 500. The index moved much higher than it previously had – coming all the way up to its upper BB.

By using Bollinger Bands in conjunction with a long-term average, you can help put the odds in your favor… at least from the perspective of technical analysis.

And in doing so, you can take advantage of the many countermoves in the markets.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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