“What happens,” a dear friend wrote me on Tuesday, “if the market just keeps going higher? Then I’m stuck on the sidelines and I’m not making any money.”
This very same dear friend wrote me a few days before Christmas to ask something like, “What happens if stocks just keep falling from here?”
And that’s the problem with rubber bands.
Rubber bands stretch, and then they snap back. But, there’s no way to tell when the “stretching phase” will end.
We can all tell when a rubber band has been stretched close to the limit. The rubber at the center of the band stretches thin. Its color fades. It even starts to vibrate just a bit.
That’s usually when it snaps back.
The stock market’s rubber band, though, is never quite as easy to read.
Oh sure, we can tell when the market has stretched close to the limit. The indexes stray historically far away from their moving averages. The technical indicators reach extreme conditions. The financial television talking heads all pile onto the same side.
That’s when the logical-thinking trader decides it’s time to bet on the rubber band snapping back.
And, that’s usually when the proverbial rubber band stretches even more. Because… the stock market never makes it easy to profit.
Extreme conditions get even more extreme. The rubber band gets even more extended. And that’s usually when I hear from my dear friend.
Anyone who trades on a “reversion to the mean” strategy – meaning we’re betting on the stretched rubber band snapping back to a normal position – has to be willing to be a little early on the trades. And, they have to be willing to suffer a bit in the short term if the rubber band stretches further than normal.
That’s just the nature of the game.
Think about it this way…
What if you bought into the S&P 500 on December 20, when the index closed at 2450? The index was extended far below its various moving averages. Most technical indicators were in extremely oversold conditions. The rubber band was stretched far to the downside.
Four days later, you would have lost over 4% as the proverbial rubber band stretched even further than you thought was possible.
But… damn… that trade looks really good today with the S&P trading near 2700. You’d be up 10%.
So… my point is that when you’re betting on the rubber band snapping back, you have to be willing to risk some short-term adverse action as the band stretches even more than you thought was possible.
But… and this is the really important point… the stock market’s rubber band always snaps back.
Yes… it sucks to be in the market as it is suffering from a historic decline. And, it sucks to be out of the market as it rallies to historic extremes.
But, chasing momentum is almost always a bad idea.
It’s far better to be a seller of stocks today than it was in late December. If you lost sleep because the stock market’s decline at the end of last year was too uncomfortable, then now is the time to lighten up on some of your positions. Trim your holdings to the point where you’ll be able to sleep if the market comes back down and retests the December lows. It’s far better to be selling today than on Christmas Eve.
And if you’re looking to buy stocks, then buying earlier this week was a bad idea. Stocks were extended. The rubber band was too stretched to the upside. It’s a far better idea to wait until the rubber band snaps back to a more neutral level, or maybe even an oversold level.
In other words… the best time to buy stocks is when the rubber band is extended to the downside. The best time to sell stocks is when the rubber band is extended to the upside.
Forget about trying to capture the perfect trade – where you buy at the absolute low and then sell at the absolute high. You’ll never do that consistently.
But, you can do really, really well by avoiding the temptation to sell or buy when everybody else is doing the same thing. Instead… just try to recognize when the stock market’s rubber band has stretched into “extreme” territory. Then, buy or sell accordingly, with the expectation of a snap-back move. And, be willing to be early.
You may take some heat in the short term. But, overstretched rubber bands just about always snap back.
Best regards and good trading,
In today’s mailbag, a new Delta Report subscriber chimes in on the service…
Jeff, I agree that the market is headed for a significant fall… I am a recent subscriber and have used options extensively in the past, but not like you do in your service. It has been primarily for income. So far, I’m excited about being a subscriber, although I’ve only executed your recent suggestion. Thanks.
What will you trade when the rubber band snaps back next? What’s your strategy when stocks are overextended?
And as always, send any other trading questions, suggestions, or stories to [email protected].