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Throughout my 40-year career, I’ve applied my mean reversion strategy across different sectors of the market for serious profits. Today, I want to dive a little deeper into how I spot those setups.

Let’s look at one of the technical indicators that I use as part of my mean reversion strategy. It’s called the Relative Strength Indicator (RSI).

The goal of the RSI is to gauge momentum. Put simply, momentum lets me see whether a stock is overbought or oversold.

If buyers push a stock too hard, the resulting rally will inevitably bring in sellers. That’s why you see pullbacks even in the strongest rallies – it’s simply too tempting for some investors not to sell at highs.

It’s a similar story with an oversold market. If sellers panic and dump their stock, the price dip will likely bring in buyers looking for a bargain. In the short term, this can drive a stock price higher.

When either scenario happens – causing a change in momentum – the RSI can provide clues for when to enter or exit a trade.

To see what I mean, let’s look at the chart of the United States Oil Fund (USO) – an ETF that aims to match the crude oil price.

United States Oil Fund (USO)

Source: eSignal

On the chart, you’ll see a number of lines…

The red line represents USO’s trend line, with the upper and lower blue lines capturing the majority (95%) of the price action.

You’ll also notice that I’ve added the RSI indicator at the bottom.

When the RSI trades above the upper horizontal dotted line (the 70 level), it indicates the stock is overbought. And when it trades below the lower horizontal dotted line (the 30 level), it indicates the stock is oversold.

On the price chart, I have placed an A, B, and C where there have been major price reversals and USO moved lower. Now match those points against the RSI below it. Take another look:

United States Oil Fund (USO)

Source: eSignal

As you can see, these major reversals have occurred when the RSI was showing that USO was overbought (green circles). That is, it was right on or above the upper dotted line on the RSI.

You’ll also notice that I’ve placed arrows at the bottom of the RSI where it shows USO was oversold. Now compare that to the subsequent action on the price chart above. The USO stock price rallied just as the RSI indicated it was oversold.

You can see just how closely the RSI and stock price can follow each other. The more you look, the more of these matchups you will see.

If the RSI is indicating an overbought or oversold position, there’s a strong possibility that a move has lost momentum. And that means a stock could be about to change direction.

When you combine that with a stock price trading outside of its trading channel (the two blue lines on the chart), that greatly enhances your chance of success.

Remember, we’re not hoping for a once-in-a-lifetime move with our strategy. Instead, we’re trying to profit from many smaller moves and put a “p” on the page.

Trading is a game of probabilities. By using the RSI as a key part of a mean reversion strategy, you can put the odds (and profits) firmly in your favor.

Happy Trading,

Larry Benedict
Editor, Trading With Larry Benedict