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How to Use the Relative Strength Index (RSI)

relative-strength-indexOne of the biggest mistakes individual investors make is simultaneously following too many technical indicators. Bull flags, bear flags, dojis, channel retracements and Fibonacci retracements are just a few of the indicators investors use to give them an “edge.”

Unfortunately, there is no “edge” when using technical indicators, particularly when used in bunches.

Most investors, particular newbies, overwhelm themselves with the latest and greatest indicators only to move on to another indicator that happens to fit their current market perspective. It’s called curve fitting and it is extremely detrimental to successful long-term investing.

Keep it simple. Believe me, early on in my career I tried almost every indicator out there on my quest to find the holy grail of indicators. But I quickly realized that it doesn’t exist. To be successful you have to find a few indicators that fit your style of investing and stick with them for the long haul. Remember, indicators are just tools to help you take the emotion out of investing. The more mechanical the investment process, the better.

I happen to be a contrarian with a strong belief in hard statistics.  So it makes sense that I would go with an indicator that measures mean-reversion.

Inherently, I prefer to fade an index whether overbought or oversold when the underlying index reaches a “very overbought/very oversold” state. Fading just means to place a short-term trade in the opposite direction of the current short-term trend.

Think of it as waiting for a well hit fly ball to hit its apex, or anticipating a bounce when that ball hits the ground. Nothing rises forever – and something that falls hard will bounce. I wait for an asset to reach extreme high or low conditions… and then get on board to ride the asset back the other way.

So with that being said, I would like to share my favorite indicator – the Relative Strength Index (RSI). But more importantly, I want to give you an example of how we can use it in today’s market.

RSI, developed by J. Welles Wilder, Jr. is an overbought/oversold oscillator that compares the performance of an equity – in our case a highly liquid ETF – to itself over a period of time. It should not be confused with the term “relative strength,” which is the comparison of one entity’s performance to another.

Basically, the relative strength index allows me to gauge the probability of a short- to intermediate-term reversal. It does not tell me the exact entry or exit point, but it helps me to be aware that a reversal is on the horizon.

Of course, other factors must come into play before I decide to invest, but I do know that, in most cases, when an index reaches an extreme state a short-term reversal is imminent.

Here is my guideline for using RSI on ETFs.

Very overbought – an RSI reading of greater than or equal to 85.0
Overbought – greater than or equal to 75.0
Neutral – between 30.0 and 75.0
Oversold – less than or equal to 30.0
Very oversold – less than or equal to 20.0

Relative Strength Index: Today’s Trade

Since I’m looking for extreme conditions, I almost always focus only on very overbought and very oversold conditions. I use three different RSI time frames – the shorter the duration of the relative strength index, the more I want to see an extreme reading. The time frames are RSI (2), (3) and (14) days.

4-3-14

The WisdomTree India Fund (NYSE: EPI) has pushed significantly higher over the past several months and is attracting lots of investor attention as of late. You can see the “very overbought” state across every RSI timeframe in the chart above. While this does not occur often, when it does, I consider it an incredible opportunity to make a high-probability trade. Of course, if EPI is on your watchlist as a buy, now might not be the best area of entry with the ETF in an extreme overbought state. In most cases, I would wait until the ETF pulls back into a neutral state before considering a position.

Knowing that the potential for a pullback in EPI is imminent, you could employ a strategy known as selling puts. I don’t necessarily want to own EPI at $19.33, particularly given the overbought nature of the ETF, but I wouldn’t mind owning it around $18, or 6.9% lower than its current share price.

I don’t want to get into the details in this short column, but we can sell one put contract that gives us the ability to buy 100 shares of EPI at $18 a share – and collect an immediate $45 per contract. And no matter what happens, we get to keep that $45. If EPI stays above $18 – the $45 we collected is ours. But for the sake of understanding, we should examine the alternative – EPI closing below $18 by option expiration.

In that case, we’d keep the $45 and be forced to buy the ETF at $18 per share. In our case, we’d actually own the ETF for $17.55 per share – that’s the $18 strike price minus the $0.45 premium. That is 9.2% less than EPI’s current market price.

One way to think about it is that you’d receive $45 on a potential $1,755 investment. This works out to 2.6% on your money while you wait for the ETF to hit your price.

Simply, selling puts is not inherently dangerous. If used correctly, it’s no more dangerous than any other type of investment. In fact, it’s often safer.

And if you’re truly interested in income, it’s something you owe to yourself to look into.

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  • gaa

    I appreciate the utility of the RSI in selecting
    the trade but I wonder about the timing of your short entry. Wouldn’t you get a better price on your short
    put if you waited until the expected reversal was already underway?