A High-Probability Strategy to Profit From Mean Reversion

Last week I discussed in great detail one of my favorite option strategies, the bear call spread. I also talked about my approach to bear calls spreads in great detail during my latest webinar. Click here to watch.
So, with that being said, I’m not going to go over the basics of the strategy. Instead, I want to dig further into the strategy by discussing a potential trading opportunity.
As you can see in the SPDR Gold Shares (NYSEArca: GLD) chart below, the GLD fund has pushed significantly higher over the past few weeks. As a result, the RSI (2) and RSI (5) are in a “very overbought” state.
When this type of short-term move occurs, mean reversion – the tendency for a stock to return to its average price – usually kicks in. In this case, GLD has moved several standard deviations away from the mean.

Think about a “very overbought” move in terms of the standard bell curve. When something is “very overbought” it has moved to the outer fringes of the curve.

There was only a 4.79% chance that GLD would push to where it’s trading now. The options market, as seen in the options chain for GLD below, stated that there was a 95.21% probability of success that GLD would close on Oct. 15 below $113.50.

So, we know the move is somewhat of an anomaly.
When a move like this occurs and we see RSI push to “very overbought” levels, I immediately want to fade the directional move. When I fade a move – in this case a bullish move – I am hoping for a short-term reprieve in the underlying price. The price could move lower, trade sideways or simply plod slowly higher. I’m just hoping for the laws of mean reversion to kick in.
But I increase my pot odds by wrapping a high-probability strategy around the trade. Rather than take a directional bias and simply buy puts, I want to sell calls, more specifically bear call spreads.
In this case, since GLD is currently trading for $113.81, I want to sell a call at a higher strike. But which strike? I always start my search with the strike that has an 80% probability of success. What that means is that at expiration in 37 days, there is an 80% chance that GLD will close below that strike.

As you can see from the option chains above, the 119 strike meets my requirements.
We can sell the 119 call strike and buy the 121 strike for a net credit of $0.27. To find the credit, take the bid price of the 119 strike we sold ($0.88) and subtract the ask price from the 121 strike we bought ($0.61).
Our return on the trade:  15.6%.
Basically, as long as GLD stays below our short strike at expiration we will reap the entire premium of 15.6%. There is a 78.48% probability of success that the price of GLD will stay below our short call strike of $119 at expiration in 37 days.
But don’t forget, we are wrapping a high-probability short-term trade on an ETF that has already pushed into a “very overbought” reading. This increases our pot odds on the trade that much further and it’s why I’m not placing trades every other day. It’s a methodical, patient approach.
More importantly, it’s an approach that has led to 23 straight winning trades in my Verticals Portfolio and 13 in my Weekly Options Portfolio in my Options Advantage service. Both take a patient approach to trading and both have a 100% win ratio for the year.
These are odds that I like to see in a trade. I hope you agree. If so, make sure you check out my latest webinar on bear call spreads.