This Trade Shows Why I Buy Weakness

If you have ever read any TradingMarkets research articles, you would know that our mantra is to buy short-term weakness. We look to buy a stock or market after it has exhibited short-term weakness, and then to capitalize on the resulting bounce back to its mean, or average price. What does this really mean for us as traders? How do we make money on this concept?

Pull up any chart of the market or a stock, and you'll see the numerous zigzag motions that the market makes as it either moves up, down or sideways. The market moves up for a time, and then pulls back for a period of time. What we are left with is a series of thrusts in one direction followed by a pause or a reaction in the opposite direction. If we were to take an average or mean of the closing prices for a specific period of time, we can visually see the thrusts moving away and then back towards the mean.

If we are to take advantage of this concept, the first thing we need to do is define the mean for what ever financial vehicle we are studying. At Connors Research Group we have used several tools to help us define the mean of the stock or the market that we are looking to trade. We have used RSI, DMI, moving averages, %b, TRIN, and others to define the mean.

Once we have established the parameters for the mean, we look for a move in the stock or market that reaches such an extreme level from this mean that a snap-back rally is highly probable. We use statistics to define the edge that exists at the moment of extreme stretch, and we look to trade the high probability snap-back, mean-reverting bounce. OK, so how do I make money on this concept? I am going to go through a recent trading example using tools from one of our most recent research products, "TradingMarkets S&P Market Timing Course".

This course takes 32 market timing strategies from Connors Research Group and combines them into one synergistic market timing course that gives you buy or sell signals as the market moves to an area of extreme stretch from its mean.

The chart above is the SPY ETF in early February, 2007. We see a market that has moved up (thrust) and is moving sideways (pause). At bar 1, we have a significant pullback and since we are trained to buy weakness, we look to see if any buy signals have triggered using the 32 Market Timing strategies that are included in the course. At the close of bar 1, which was February 9th, we do not get any buy signals that have triggered yet, but we are ‘thinking buy’ at this point. On the next day (bar 2) we see further weakness in the SPY and we get 7 market timing signals to trigger. One of these signals is shown at point 4 in the RSI indicator shown below the price.

So at this point, we have defined the mean using the 32 strategies and have identified an area of extreme stretch from this mean. Our research shows that this is a high probability trade, so we enter the market at the close of bar 2 (02/12/07).

We bought the SPY at 143.45 at the close, as well as deep in-the money calls on the SPY. We then bought the February 138 SPY calls to minimize time premium. On the next day, (bar 3) we get a very nice mean-reverting bounce and get our sell signal, which is highlighted at point 5 on the 2-period RSI below the price. We exit our SPY at the close at 144.65 for a nice 1.20 profit as well as our SPY options for a 1.10 profit.

This trade highlights the benefits of buying weakness. We first defined a mean for the market using a system of indicators. We then identified an area of extreme stretch from this mean where statistically the probabilities for a snap-back rally are great. We then acted by buying the SPY ETF and deep in-the-money SPY options. We then witnessed the power of the mean-reverting snap-back rally as the market moved up strongly on bar 3.

Learn more strategies like this in the "TradingMarkets S&P Market Timing Course". To listen to a free Market Timing presentation led by Paul Sabo and Larry Connors, click here.

Paul Sabo has been a professional trader for over 18 years. During this time he has worked as a market maker in both New York City and San Francisco for some of Wall Street's most prestigious investment banks, commercial banks and brokerage houses. Paul later became the head trader for a top-ranked investment advisor and hedge fund based in San Francisco. Paul recently left his position at the hedge fund to trade his own money as a full time business as well as working with Connors Research Group on various proprietary projects.