In September, historically a challenging month for the markets, a significant correction often occurs. This year began on a weak note but quickly turned bullish following an unexpected half-point rate cut by the Federal Reserve. Several sectors, including consumer discretionary, have experienced a notable rally, potentially necessitating a cooling-off period. When a stock or ETF becomes overbought, it can remain in that state for an extended time. However, technical analysis can identify signs of a mean reversion setup. Many of these setups are elaborated upon in the book "Mean Reversion Trading."
An analysis of the one-year daily chart of Consumer Discretionary Select Sector SPDR (XLY) has highlighted two similar instances in the past. XLY might replicate this pattern again. The following technical indicators were used for this assessment:
Directional Movement Index (DMI): When the DI+ (green line) is above the DI- (red line), the stock is in an uptrend. A potential shift in the current trend is signaled when these DI lines begin to reverse direction. This scenario occurred on December 19, 2023, and July 9, 2023, and appears to be happening again.
- Relative Strength Index (RSI): The RSI measures the strength of a trend as a stock rises. A rising RSI suggests a strong trend, but when it exceeds the 70 mark, the stock or ETF is considered overbought and may revert to the mean. In overbought conditions, it is advisable to wait until the RSI falls below 70 before considering a contrarian trade.
Notably, the week is packed with job-related data including the ADP report on Wednesday, the jobless claims report on Thursday, and the non-farm payrolls report on Friday. Should any of these reports indicate labor market weakness, the described setup could unfold rapidly.
To capitalize on a potential pullback in XLY, a "bear put spread" trade structure can be employed. This involves purchasing a higher strike put and selling a lower strike put simultaneously for a net debit. The exact trade setup is as follows:
- Buy $205 put, expiring October 25
- Sell $200 put, expiring October 25
- Limit Price: 2.50
If XLY trades at $200 or below on the expiration date, this trade will yield a 100% return on investment of the amount risked. Alternatively, a smaller spread using 200-199 strikes for a $0.50 debit can be bought, risking only $50 per trade as opposed to $250 in the initial setup.
Nishant Pant
Founder: Trading Extremes
Author: "Mean Reversion Trading"
Youtube, Twitter: @TheMeanTrader
Disclosures: Nishant currently holds an XLY 205-200 bear put spread expiring on 10/18/2024. All opinions expressed by CNBC Pro contributors are their own and do not reflect those of CNBC, NBC Universal, their parent company, or affiliates and may have been previously disseminated on other platforms. The above content is subject to terms and conditions and privacy policy. This content is provided for informational purposes only and does not constitute financial, investment, tax, or legal advice, or a recommendation to buy any security or other financial asset. The content is general in nature and does not reflect any individual’s unique personal circumstances. It may not be suitable for all circumstances. Before making any financial decisions, consulting a financial or investment advisor is strongly recommended.
