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As I suggested in my previous article, the S&P 500 might be ripe for a correction. So how can we profit from that likely occurrence?

According to some history reports, in the midst of the bloody fight between the Prussian and the French for the control of Paris in 1871, a young man inherited a huge fortune. Asking for investment advice from the already iconic Baron Rothschild, he got the suggestion to buy French equities because you should "buy when there's blood in the streets." At the time, the streets were covered in real blood from the recent battles, but what the banker meant was to profit from panic selling in order to buy at bargain prices.

Unfortunately, it is very difficult to get the right timing, to have an understanding of the market dynamics, and to be financially able to stand temporary losses to finally make a profit from the discounted purchase. After the Lehman collapse, there was certainly enough blood on Wall Street. But buying the equity market in late September 2008 would have required a strong commitment to hold on to the position until at least Q4 2009, ignoring temporary losses of up to 35%, which is not always feasible given regulatory or liquidity constraints.

That's why we suggest a simple (yet effective) strategy to profit from a short-term market reversal in a way that significantly reduces the downside risk. The idea is to buy the market just before the close on days with sizable pullbacks, and sell it just before the close the day after. This can be done through a simple broad ETF such as the SPDR S&P 500 (SPY) or through leveraged ETFs such as the ProShares Ultra S&P 500 (SSO) and the ProShares UltraPro S&P 500 (UPRO). SSO and UPRO amplify the impact of the strategy as they magnify the index performance by 2 times and 3 times, respectively.

The following graph shows the cumulative performance of a strategy that buys the market just before the close on days when the S&P 500 drops below a certain return threshold (-1%, -2%, -3%, -4%, and -5%) and holds the position for one day, selling it just before the close the day after.

We've compared those returns with the cumulative performance of the S&P 500 for the period from January 2001 through August 2012:

Click to enlarge images.

As you can see, all the strategies deliver consistent outperformance, meaning that the market structure implies pronounced short-term price reversals. Given the limited bid/ask spread and overall costs of the ETFs used to exploit these market inefficiencies, the strategy can be highly profitable. Moreover, the leverage effect can lead to substantial upside potential.

Here is a table with some summary statistics:

The strategy in all its variations has a higher hit rate (observations with positive returns/total observations) than a simple buy-and-hold strategy, and has significantly higher average returns. Moreover, the downside risk as measured by the worst-day return is also lower.

Clearly, this is a more demanding trading rule as the -5% threshold causes a reduced number of periods in which it is possible to deploy the strategy, but the lower activity is compensated by a higher hit rate. For this time interval, for example, there was virtually no active position for periods of up to seven years. The -1% trading strategy is understandably much more active and allowed far better returns than the S&P 500 for the period under examination.

One last suggestion: Keep the discipline, follow the rule and sell the day after (don't try to recover a loss by holding the position too long). This will maximize the statistical likelihood of reaping the strategy returns in the medium/long run.

Source: Buy When There's Blood In The Streets