September, typically a challenging month for the markets, often leads to significant corrections. This year, it started on a weak note, but quickly turned bullish after the Federal Reserve surprised everyone with a half point rate cut. Several sectors, including consumer discretionary, have experienced a substantial rally, reaching levels that may require a cooling-off period. When a stock or ETF becomes overbought, it can maintain that condition for an extended period. However, technical analysis can help spot indications of a mean reversion setup. Many of these setups are explained in my book Mean Reversion Trading . In the one-year daily chart of Consumer Discretionary Select Sector SPDR (XLY) below, I’ve highlighted two similar instances from the past. XLY might be poised to replicate this pattern again. To make this assessment, I used the following technical indicators: 1. DMI (Directional Movement Index): When the DI+ (green line) is above the DI- (red line), the stock is in an uptrend. However, when these DI lines start to reverse direction, it signals a potential shift in the current trend. This scenario played out on 12/19/2023 and 7/9/2023, and it appears to be happening again. 2. RSI (Relative Strength Index): As a stock rises, the relative strength index (RSI) measures the strength of the trend. A rising RSI suggests a strong trend, but when it crosses above the 70 mark, the stock or ETF is considered overbought and likely to revert to the mean. Once in overbought territory, it’s advisable to wait until the RSI falls back below 70 before considering a contrarian trade. It is worth noting that this week is filled with jobs related data including the ADP report on Wednesday, jobless claims report on Thursday, and the non-farm payrolls report on Friday. If any of these reports point to weakness in the labor market, the set-up described above could unfold rapidly. The trade To benefit from a pullback in XLY, the trade structure I am going to use is called a “bear put spread”. This involves buying a higher strike put and selling a lower strike put at the same time for a net debit. Here is the exact trade setup: Buy $205 put Oct 25th expiry Sell $200 put Oct 25th expiry Limit Price: 2.50 If XLY is trading at $200 or below on expiration date, this trade will generate a 100% ROI on the amount risked. It is also possible to buy a smaller spread using 200-199 strikes for .50c debit which will risk only $50 per trade instead of $250 as described in this setup. -Nishant Pant Founder: https://tradingextremes.com Author: Mean Reversion Trading Youtube, Twitter: @TheMeanTrader DISCLOSURES: (Nishant currently has a XLY 205-200 bear put spread expiring on 10/18/2024.) All opinions expressed by the CNBC Pro contributors are solely their opinions and do not reflect the opinions of CNBC, NBC UNIVERSAL, their parent company or affiliates, and may have been previously disseminated by them on television, radio, internet or another medium. THE ABOVE CONTENT IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY . THIS CONTENT IS PROVIDED FOR INFORMATIONAL PURPOSES ONLY AND DOES NOT CONSITUTE 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. THE ABOVE CONTENT MIGHT NOT BE SUITABLE FOR YOUR PARTICULAR CIRCUMSTANCES. BEFORE MAKING ANY FINANCIAL DECISIONS, YOU SHOULD STRONGLY CONSIDER SEEKING ADVICE FROM YOUR OWN FINANCIAL OR INVESTMENT ADVISOR. Click here for the full disclaimer.
