By Gabe Velazquez, Online Trading Academy E-minis Instructor
Back in December of 2008, I wrote an article entitled, "The Rubber Band Effect." In it, I discussed the propensity of the market to overshoot in both directions, and the opportunities that the "reversion" trade usually presents. I spelled out the technical tool that I use and the rules associated with that particular set up. In this article, I'm going to revisit this phenomenon, and explain the workings behind why the market has a strong tendency to revert to the mean.
The premise is quite simple behind why a market that has gone "too far, too fast" typically has swift and violent corrections. Let's think of it in terms of what really happens: Buyers and sellers have become considerably out-of-equilibrium. When the market has moved dramatically in one direction, the implication is that at some point, the trade will become crowded. In other words, it's either over-owned, under-owned, or excessively shorted.
Think of it this way, a rising stock continues to attract buyers as long as it continues to reward those that purchase it. At some point, however, the demand for that stock will lessen. This happens for several reasons. One reason may simply be that everyone wanting to own the stock already does (including those owning it on margin). Therefore, who is left to buy? If that's the case, the equation of buyers (very few left), and sellers (a huge amount) becomes clearer in terms of what direction the price is likely to move. The questions now become, from what level and when will this occur? There first needs to be a catalyst to spur the selling, and it doesn't have to be big. Just as a single snowball can cause an avalanche when the conditions are right, so can a small amount of selling trigger a bigger correction.
Another scenario is where the smart money (institutions who purchased shares early in the move) will begin to distribute their shares to the unwitting retail investing public which doesn't understand market dynamics. This selling creates the supply that prevents a stock from advancing, and eventually overwhelms any superficial buying made by the latecomers.
In the downside momentum, all we have to do is change the players. The short sellers push prices down, and the longs have sold all their stock. The equation shifts so that all that's left after a steep decline is a pile of cash on the sidelines and tons of stock that has to be covered (returned to whom it was borrowed from). You get the picture.
The obvious question from a trader's perspective is how an extended market looks on a price chart. One way to distinguish if a market is ready for a correction is the angle of trajectory. As a rule of thumb, the steeper the pitch, the more vulnerable a stock or market is to a pullback. Typically, when the pitch is more than 50 degrees, a retracement is imminent. Below is an hourly chart of the TF (Russell 2k E-mini). Note the 60-degree angle of the recent advance. This indicates to me that a shorting opportunity is forthcoming.
Figure 1 The next step in setting up a trade - once the determination has been made that a retracement is upcoming - is, of course, where to short. I've highlighted the next sell zone, which would be ideal for shorting.
However, let's say you don't want to wait for the price to reach that zone. In that case, you'd want to spot sellers who appear in the short-term to identify a low risk entry.
In the 5-minute chart below, we can see a minor area of selling highlighted in yellow. Take note at how the price pierced that level, albeit by only 5 ticks, but gapped down in the Globex session. If the minimum 15-tick stop for trading the Russell were placed in this instance, that stop should have held.
Figure 2 All told, the "extremes" are where the lowest risk, highest reward trades can be found. As I've said in many of these articles, this type of trading is not for everyone as it involves trading against the trend and fading strong moves. Having said that, I only trade against the trend when the trend is "long in the tooth" and stretched, and not when it's just emerging.
As Galileo's famous experiment proved that "what goes up, must come down," so, too, do financial markets. And the opposite is true for the major averages and sectors in that "what comes down, must go up" - eventually. We have to be very careful, however, in adapting that philosophy to individual stocks because we know that's not always the case. Lehman Bros, Bear Stearns, and General Motors are examples of stocks that have defied gravity.
Until next time, I hope everyone has a profitable week.
If you have questions or comments, please email me at gvelazquez@tradingacademy.com
- Gabe Velazquez
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