S&P 500 Mean Reversion: She’s a maniac, maniac on the floor!
Nope, I’m not talking about the talented Jennifer Beals in Flashdance, I’m talking about the not-so-sexy, totally maniacal, crazy stock market.
Specifically, mean reversion of the S&P 500.
I want this hard-wired into your brain; ingrained in your skull for the rest of your life:
The stock market is constantly in a love-hate relationship with the public, and that’s precisely how you can make a fortune trading it.
Got it? Good, OK, end of post. Just kidding.
Go back and look at times when the stock market was totally disparaged: the day of the Brexit vote, the days right before the 2016 election, the day Trump fired James Comey.
Prices sold off hard, turning into huge down days and everyone was deep in despair.
Then, wham bang, everything’s great and the market soars!
What the heck? How can everyone be so wrong one day and then so right the next?
This, my friend, is the true nature of the modern stock market since the introduction of stock index futures in 1982 (which I wrote about previously).
It takes guts to trade the S&P 500
When looking at the stock market through this new lens, those extreme moments of despair turn out to be amazing buy opportunities.
Since we trade on the extreme right side of the chart aka “the future”, we don’t know what’s going to happen the next day.
I know this from experience if you wait around for the “all clear” to sound you are going to miss out a ton of money.
It takes guts to step into the market after one or two very bad days.
But you can’t wait for some indicator to start turning around, you literally have to buy when the mania is at its peak.
Waiting for candlesticks reversals and all that baloney cuts into your profit margin big time.
Why does the stock market act like a ping-pong ball?
I personally don’t like asking “why” too much when it comes to investing and trading.
Asking why doesn’t get you anywhere and you’ll lose a lot of time debating unprovable "economics" (which is NOT a science) with your friends and colleagues.
I unequivocally advise staying away from philosophical questions when it comes to money.
For me, “it just does”, is all I need to know.
But I will indulge for one little moment:
It all goes back to stock index futures which allow people to control massive amounts of money with a small amount of money, known as leverage.
When one futures contract of the S&P 500 is worth around $100K and can be controlled by just $5,000, you are going to have a lot of volatility in the market.
It also allows for tremendous liquid, which is a good thing, but the volatility this leverage brings to the table is the true reason for Mr. Crazy Pants stock market.
Agony to ecstasy and back to agony.
How to trade the mean reversion of the S&P 500
Knowing that the stock market pops back and forth like a ping-pong ball means we can make a ton of money buying dips in an up-trending market and selling rallies in a down trending market.
The framework is remarkably simple:
Define the trend of the market, up, down or sideways.
Can be done using moving averages like the 200-day moving average.
Define a dip in prices.
How much has price moved below the 5-day moving average?
Sell when the market close back above the 5-day moving average.
Rinse and repeat!
Reverse the rules and make money when the stock market is falling
When the big nasty bear eventually comes back to the stock market, we can still make money by shorting it.
Taking the above framework and inverting the rules does the trick!
Fear is twice as motivating as greed and stocks tend to fall twice as fast they rise.
As such, it's not uncommon to make a tremendous stack of money in the relatively short time bear markets occur.
Go us traders!
Mean reversion is a gift that keeps giving
Knowing the difference between mean reverting and trend following markets is a gift.
By applying the right tools, i.e. the right trading systems, to the correct markets, you can "catch fish" for a lifetime.