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One of the biggest mistakes I see new traders making is that they keep digging into the toolbox for a new widget every time they see something they like.
I can’t tell you how many traders that I know that want to follow bull flags, bear flags, candlestick patterns, channel retracements, Fibonacci retracements – the list goes on and on. They will try and teach you about their long list of indicators to make themselves look impressive, but in reality most are horrible traders over the long-term because they overwhelm themselves stream of the latest and greatest indicators only to move on to another indicator that happens to fit their current market perspective.
I keep it super-simple when I trade. I pick one tool and I use it for its specifically intended purpose. For me as an options trader, I’m looking to make steady, reliable gains without too much of a holding period.
So in order to make options trades I use a tool that helps me do a few things:
1) It alerts me that a profitable trade may be on the horizon – which gives me time to prepare.
2) It tells me when I should think about getting out.
3) It lets me adjust my time horizon to craft a trade that fits my needs.
As I said before I keep it very simple. I use a few basic versions of ONE simple tool model to take advantage of sentiment and technical extremes on highly-liquid ETFs.
So, with that being said, I would like to share with the most powerful technical indicator that I use in my proprietary model.
The Relative Strength Index (RSI), developed by J. Welles Wilder, Jr. is an overbought/oversold oscillator that compares an entity’s performance 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.
RSI 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.
Basically, my indicator 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.
Knowing that a short-term top/bottom is near I am able to increase the probability of a potential trade. Conversely, knowing that a reversal is on the horizon I am able to lock in profits on a trade.
For I am a contrarian at heart and 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.
Of course, other factors must come into play before I decide to place a trade, but I do know that, in most cases, when an index reaches an extreme state a short-term reversal is imminent.
The following is the baseline for my indicator:
Very overbought – a reading of greater than or equal to 80.0
Overbought – greater than or equal to 70.0
Neutral – between 30.0 and 70.0
Oversold – less than or equal to 30.0
Very oversold – less than or equal to 20.0Keep it
Since I’m looking for extreme conditions, I almost always only focus on very overbought and very oversold conditions. When an asset hits more neutral levels, that’s an indication to close the trade out.
Next week I will go over an example or two how I use RSI in my daily trading, particularly in the Options Advantage portfolio. Stay tuned!
If you have any questions about the intricacies of the strategy or using probabilities of success as a way to trade/invest please feel free to email me at [email protected], and follow me on Twitter at @OptAdvantage.
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