If you learn only one tool of technical analysis, then master the art of the 9-day exponential moving average (EMA).
The 9-day EMA is a weighted average of the daily price of a stock or index over the past nine trading sessions. Lots of traders use moving averages to indicate short-term support or resistance levels. And I often use the 9-day EMA for that purpose with many of the trades I recommend to subscribers.
For a “reversion to the mean” trading strategy, the 9-day EMA is an excellent measure of short-term overbought and oversold conditions.
Think of the stock market as a giant rubber band. As the market moves up or down, the rubber band stretches. When conditions hit overbought or oversold levels, the rubber band is stretched tight. At extreme overbought or oversold levels, the band is so tight that a snap back to a normal level is inevitable.
The 9-day EMA is that “normal level.”
For example, the S&P 500 rarely strays more than 30 points or so from its 9-day EMA before snapping back towards the line. It does happen… but it’s rare. Whenever the S&P trades more than 30 points above or below its 9-day EMA, the odds of a snap-back move increase. And traders have the opportunity for a quick reversion trade.
Normally, we’ll get this sort of trade setup 20 or more times each year. But that didn’t happen much in 2017. Because of the low-volatility environment, the S&P 500 traded 30 points above or below its 50-day MA only a few times.
One such time was in early March. You can see from the following chart how the snap back happened almost immediately…
Aggressive traders could have taken a short position on the S&P 500 at 2395. Then, they could have closed the trade just a few days later when the index declined to its 9-day EMA.
As I said, though, in 2017 these sorts of trading opportunities were rare. So, let’s go back to when the markets used to have some volatility, and when these types of trades were more frequent. After all, that’s the sort of environment I think we’ll have in 2018.
So, here’s a chart of the S&P 500 from mid-December 2014 through mid-January 2015, plotted against its 9-day EMA. We had five of these “rubber band” trades trigger in just one month…
The vertical blue lines on the chart show when the S&P 500 was 30 points or more below its 9-day EMA and I recommended “buy” trades on the index. The red lines show when the S&P 500 was 30 points or more above its 9-day EMA and we executed “short” trades.
In this five-week period, I recommended eight trades based on the market’s proverbial rubber band being stretched too far from the 9-day EMA. And all of them generated fast, short-term profits…
|Date||Action||Closing Action||Days in the Trade||Percentage Return|
|12/16/14||Bought S&P 500 @ 1976||Sold @ 2012||0 (day trade)||1.82%|
|12/16/14||Bought S&P 500 @ 1990||Sold @ 2007||1||0.85%|
|12/24/14||Shorted S&P 500 @ 2080||Bought @ 2066||9||0.67%|
|01/06/15||Bought S&P 500 @ 2014||Sold @ 2018||1||0.20%|
|01/06/15||Bought S&P 500 @ 2006||Sold @ 2034||1||1.40%|
|01/14/15||Bought S&P 500 @ 1997||Sold @ 2010||1||0.65%|
|01/21/15||Shorted S&P 500 @ 2028||Bought @ 2006||0 (day trade)||1.08%|
This type of “rubber band” setup is a high-probability trade. The S&P 500 rarely strays more than 30 points from its 9-day EMA before snapping back. On those rare times when the rubber band stretches exceptionally far, the trade may take longer than a day or two to play out. But it almost always does so profitably.
The rates of return are relatively small. But, keep in mind, were talking about trades that usually only last about one or two days. String enough of these trades together and it can have quite an impact on your account performance.
Also, the percentage return figures in the table are based just on the value of the S&P 500. Gains are doubled for traders who use one of the leveraged ETFs (like SDS or SSO). Option traders can earn four or five times the return.
This “rubber band” strategy using the 9-day EMA can also work quite well with individual stocks. But, you have to determine the relationship that each stock has with its 9-day EMA. For some stocks, the rubber band might be considered extremely stretched when the stock price is 5% or more away from its 9-day EMA. For other stocks, it might take a move of more than 10% to set up a good trade.
Volatility was quite muted all throughout 2017.
And, since periods of low volatility are always followed by periods of high volatility, I expect we’ll have plenty of “rubber band” trades in 2018.
In next Monday’s Market Minute, we’ll look at one more way to profit off volatility.
Best regards and good trading,
P.S. Each weekend, I look over hundreds of stock charts to find the patterns that’ll most benefit my Delta Report subscribers. And the 9-day EMA is just one of the many tools I use to find big, fast gains week after week.
But there’s a special catalyst right around the corner. It’s one of my favorite times of the year to trade… because it brings those high-upside trading patterns out of the woodwork… and into my subscribers’ inboxes.
To learn a little more about this catalyst, and how my Delta Report subscribers take advantage, click here.