We are going way back in time for today’s visual for the blog. Lets be honest here, who remembers Stretch Armstrong? I have to admit that it was definitely a part of my childhood and that should give you a solid indication of my actual age. LOL So what could a child’s toy possibly have to do with trading? That will be the focus of this week’s blog. Let’s begin.
One can see that Mr. Stretch Armstrong has a certain talent and that talent is that he can stretch quite a ways beyond what would be considered reasonable or normal. This is also true of the markets is it not? Have you ever looked at a chart and thought man, this can’t go any further and then you look at it a week later, and it just kept on going? This happens all the time in the markets but much like Stretch Armstrong has his limits the equities and the markets have their limits as well. This push to the limits and subsequent reversal move is called a reversion to the mean. Stretch Armstrong always comes back to a normal type look and all the equities do the same the only difference is we don’t know exactly when that will happen for any particular equity or market, or is there?
One of my mentors used to say that “the markets never announce themselves” and he was right but the markets sometimes leave us clues as to their intentions. We can see this by looking at price movement and we can see this by momentum slowing through smaller candles and shorter pullbacks. There is also another way to see changes in the market or the equities. These changes are when things are so overstretched that a reversion to the mean is on deck. One of the easiest ways to see when these reversions is likely to happen is to use an indicator. There are plenty of overbought and oversold indicators but I think one of the easiest is the Bollinger Bands.
We can use the Bollinger Bands to see when things are getting very overstretched and this indicator can even signal approximately when the reversion has started. Take a look at the chart of the SPY below and you will see that the candles have gotten outside the upper bands of the indicator. This is the first sign that things are overstretched. This does not tell us whether the reversion to the mean has started but it does give us a heads up that things are getting outside of what could be considered normal movement. Much like the Stretch picture above where he is being held out, the stock can remain stretched out for a long undetermined amount of time as long as the buying pressure remains. We can see that back in January the candles stayed outside the bands for several candles but eventually closed inside the Bollinger Band and this is where things change. At this point, this is the start of the overstretched condition to be relieved and the start of the reversion to the mean. As you can also see this reversion is not always a straight shot but this close inside the band is the signal that the reversion has started.
We can use this signal as a heads up that things are changing and you should be prepared for at least a short-term reversal in trend. So if you see those markets or equities that just don’t seem to end then this is a good way to be ready for when they do.
So, just like the snapback of Stretch Armstrong, we will always see the snapback in the markets and we just need to keep our eyes open to prevent being a victim to the same problems that Stretch has to deal with.
Coach “Old Money” Holmes