Volatility Reverts to the Mean

From 1990 to 1997, Kevin Haggerty served as Senior Vice President for Equity Trading at Fidelity Capital Markets, Boston, a division of Fidelity Investments. He was responsible for all U.S. institutional Listed, OTC and Option trading in addition to all major Exchange Floor Executions. For a free trial to Kevin’s Daily Trading Report, please click here.

The SPX declined -6.9% in 8 days from the 1/19 1150.45 high to the 1071.59 low on Friday (1/29). The decline was from an anticipated key price and time zone, which was also ST-O/B, so the probability for a reversal was high.

Earnings season always gets lots of hype, and this one has been no different. This QTR was expected to be an easy comparison to Q4 (Recession of 2008), and it is as over 70% of reporting companies have beaten greatly reduced estimates due mostly to cost cutting and layoffs, but that is not the case for top line growth. The Generals and hedge funds were doing some selling into the news and taking some money off the table.

The technology and materials sectors have declined the most since earnings season started, and were the most O/S going into the 1/29 lows. Also, the Energy and Materials sectors were down four straight days going into their Friday lows, so the odds were obviously in favor of a quick reversal, which is what we anticipated in the Trading Service.

I have included the XLB, XLK, and SPX 3-month Standard Deviation charts, which highlights how extended they were after the Friday lows. When markets get extended volatility will revert to the mean, which is one of my core trading tenets in all of my trading modules, regardless of whether you are a Day Trader, Swing Trader, or longer term investor.

The -2.0 STDV zone has a 95% probability of a reversal, and the -3.0 level a 99% probability. The STDV levels are dynamic, so traders have to seize the opportunity when price hits these zones for the highest potential return. However, you can’t know the duration or extent of a move, so that is why they call it trading, but you can recognize these high probability reversal zones in any time period, and that puts the odds in your favor if your are consistent in taking advantage of them.

There is a problem with the commentary archives on the Trading Markets site that is being worked on, so a few emails from you might expedite the transition. My normal commentary days are Tuesday and Thursday, but if you don’t see one on a Tuesday then you should expect it on Wednesday and Friday.

Have a good trading day!

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