Markets often exhibit tendencies that, for the astute trader, may translate into profits. One such tendency is what I refer to as the ?rubber band effect.? The fact is that markets tend to overshoot, similar to a rubber band that?s stretched to its extreme and then has to snap back to its normal tension. This theory is based on the premise of ?mean reversion? which is simply that when the price of any market deviates substantially away from its medium price (otherwise known as an ?outlier?) the odds increase ?substantially that it will revert back to the average.
This hyper-extension of markets has to do with the herd mentally of market participants and is essentially what panic or euphoria look like on a price chart. This pattern is repeated quite often in the markets and is worthwhile in identifying, as it often times serves to uncover some very attractive risk/reward opportunities.? Professional traders refer to these moves as the ?extremes? because it?s these moves that pit the novice against the professional.?? The key to making this profitable is gauging how far is too far.
There are various indicators that measure the distance price has traveled away from the average.? The most popular are the Bollinger bands, but there are others such as Keltner channels and moving average envelopes. These use a 20-period average and can calculate a standard deviation, percentage, or average true range to calculate the envelope or bands. ?These indicators can be of some help in measuring how far the rubber band is stretched, but we have to be careful as the markets can and often do move further and faster than anyone could have anticipated.
Instead, if we think in terms of order flow we can infer that markets will continue falling until they are met with an imbalance of buy orders. Conversely, markets will continue to rally until all the buyers are gone and only sellers remain.? As simple as this seems quantifying order imbalances can be quite difficult unless you have the proper training.
In a recent Futures XLT class I conducted we spotted a level in corn? that based on the criteria we use at Online Trading Academy ?we deemed as a supply zone. ?As you can see from the picture below price was quite a bit below the zone when we indentified it.? So we expected price to return to the area and turn down.? We also had a potential catalyst in the way of a crop report the following Friday.? And from viewing the second caption, we can see that is indeed what happened. ?The positive crop report catapulted corn prices into the ?sell Zone? and turned dramatically lower.? The rubber band had stretched far enough that it ran into supply and the reversion to the mean began.? Also, notice how far prices fell away from that level.? There is only one reason why prices drop that sharply, and that was because there weren?t any buyers until around ?the 713-712 area .? In this instance the rubber band stretched a bit further because of the supply and demand equation.
Since the day of the US election, the equities market has seen a steep decline and most people (that is those people that are long stocks) have been asking when the selling might be arrested, or when the turn around is coming.? No one knows for certain, but I can tell you that when we approach that level of buy orders on the charts, we will certainly make our students aware.? And? the great part about this is that if we?re wrong,? we will lose very little to find out.? But on the other hand if we?re right, the reward should ?be handsome.