Managing Editor’s Note: Today, we’re handing the reins over to colleague Larry Benedict – a market wizard and legendary hedge fund manager.
Trading with a plan can edge you out from other traders, but only if you have the right tools at your disposal. Larry shares the two key indicators he believes can set you up for success…
Here’s Larry with the insights…
How I Put My Trading Edge in Action
By Larry Benedict, editor, Trading With Larry Benedict
All it took was 16 days to generate a 69% gain.
I shared more about our recent Invesco QQQ Trust Series 1 (QQQ) trade on Monday, which you can find here.
But today, I want to dig into the details of the strategy I use with trades like this.
“Mean reversion” is one of my favorite trading tactics.
I identify when a short-term price trend is losing momentum.
When a trend goes too far in either direction, I look to profit when it snaps back… like a rubber band after you stretch it.
And after trading the markets for 40 years – including a 20-year winning streak during my hedge fund days – I’ve developed a feel for when a trend is running out of steam.
But you don’t need to spend decades figuring it out.
Today, let me show you how to use two technical indicators to spot high-probability mean-reversion setups…
Tools of the Trade
Technical indicators can reveal the health of an underlying price trend. They can also show if a reversal is in store.
And two indicators are key for spotting mean-reversion trades.
The first is the moving average convergence/divergence (MACD).
It’s a mouthful to say. Yet the indicator simply compares the distance between short- and long-term moving averages.
When the shorter-term average strays too far from the longer-term average, that tells you to be on the lookout for mean reversion.
The second indicator is the Relative Strength Index (RSI). The RSI measures price momentum for a given stock or index.
The RSI can help us spot overbought and oversold conditions. And it can also deliver an early warning that a price trend is losing strength.
Here’s how to combine these signals to spot trading opportunities…
Calling the S&P 500’s Recent Top
The MACD tells you when a trend is getting stretched too far in one direction. That happens when the indicator moves too far above or below the zero (0.00) line that you’ll see in the chart below.
That’s your sign to be on the lookout for a pending reversal.
And when the MACD shows the potential for mean reversion, you can use the RSI to spot weakening price trends.
So let’s use the recent top in the S&P 500 this year to show this strategy in action.
In the chart below, the middle panel is the MACD (the black line along with a pink signal line), and the bottom panel is the RSI.
Source: eSignal
The S&P 500 rally over the past year has pushed the MACD to elevated levels on several occasions (shaded boxes).
These overbought conditions produced pullbacks of varying sizes.
Yet you’ll notice that the MACD can stay at a high level for an extended period. So we need another indicator to show us when to pull the trigger on a potential trade.
That’s where the RSI comes in. It can flash warning signs of an impending reversal.
Look at “1.” The S&P 500’s price made a new record high.
But the RSI sank from “A” to “B” – a lower high. That negative divergence showed momentum behind the uptrend was weakening.
Just as the RSI flagged its warning sign, the S&P 500 peaked on July 16.
Since then, it has fallen 4%.
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Putting It All Together
While no indicator is perfect, the combination of MACD and RSI can be a potent signal for traders.
So if you’re looking for a way to add mean reversion to your trading repertoire, don’t neglect them.
Plus, keep in mind that MACD and RSI can also signal when it’s time to exit a trade.
They can tell you when your reversal snapback starts petering out… and you’re due to start taking profits.
Happy Trading,
Larry Benedict
Editor, Trading With Larry Benedict