Managing Editor’s Note: Today, we’re handing the reins over to colleague Larry Benedict – a market wizard and legendary hedge fund manager.

Today, he’ll tell you about how he captured a great reversion-to-the-mean trade for his readers.

Here’s Larry…

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Even before the rout on August 5, a huge money flow was already underway…

The major indexes (including the Nasdaq and S&P 500) topped out in July. Investors were dumping stocks as a major pullback took hold.

By the time both bottomed out on August 5, they’d lost almost 16% and 10%, respectively.

Throughout that flight to safety, a big chunk of that money found its way into bonds. Weakening economic data exacerbated that move. (Note that bonds increase in value as the likelihood of rate cuts intensifies.)

But like any switch in money flow, that move can become overdone…

And that’s what we saw with bonds.

By August 2, the iShares 20+ Year Treasury Bond ETF (TLT) was trading in overbought territory. It looked vulnerable to a fall.

Not only did we get that call right and prosper from a down move… we also caught the next move when TLT bounced.

Today, I want to show how we pulled off two winning trades on a single stock among all the market carnage…

Capturing a Fall

In the chart of TLT below, you can see its sharp rally from mid-July. TLT leaped above its 50-day moving average (MA, blue line).

That move coincided with momentum turning higher as well (green circle), as shown by the Relative Strength Index (RSI).

iShares 20+ Year Treasury Bond ETF (TLT)

Source: eSignal

But that surge in buying soon put the RSI into overbought territory (upper gray dashed line). And that move looked overdone.

That’s the type of scenario I look for to capture a mean-reversion trade. I aim to profit when an overstretched price snaps back the other way.

So on August 2, we bought a put option on TLT. A put option increases in value when the underlying stock falls.

Although we were a little early with the trade, it proved to be the right call…

After peaking on August 5, the RSI formed an inverse “V” at “A” and retraced from overbought territory.

As the chart shows, TLT declined as momentum steadily fell.

Our position was in good profit, and TLT’s down move stalled that day. So we exited our position by selling our put option on August 7.

That enabled subscribers of my option advisory The Opportunistic Trader to generate a 34.5% gain. That’s a handy profit in just five days.

But with that reversal to the downside looking overdone, we next decided to set ourselves up for a bounce.

We just needed to wait for the right setup…

Trading Both Directions

That setup appeared the following day when the RSI reversed at “B.” The move coincided with TLT trading around $95. That was a key support level from which I believed the stock would rally.

Take another look:

iShares 20+ Year Treasury Bond ETF (TLT)

Source: eSignal

In anticipation of a rally, we bought a call option on TLT on August 8. A call option goes up in value when the underlying stock increases.

And again we made the right call…

TLT gapped higher the following day but then reversed off its highs. So we played it safe and closed out our TLT position by selling our call option.

That netted those subscribers who placed the trade a 15% gain in a single day. Altogether, traders who took part in both positions generated a combined 49.5% gain in a week.

Now, remember, options magnify both gains and losses. And because options have a finite life, the clock is always ticking down to expiration.

So if the move you planned for doesn’t pan out, you can lose all the premium you paid if you hold the option through expiry.

But as this trade shows, options are a great tool to profit from sharp reversals. We can generate outsized gains quickly…

And among all the market carnage, it enabled us to generate a nearly 50% return in a single week.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict