Relative Strength Index: A Sample Trade

In my last post I went over the basics of the Relative Strength Indicator, otherwise known as RSI.
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.
The S&P 500 (NYSE: SPY) has pushed significantly higher over the past several days and is attracting lots of investor attention as of late. You can see the “overbought” to “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 SPY 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 SPY is imminent, you could employ a strategy known as selling puts. I don’t necessarily want to own SPY at its current price, $198.43, particularly given the overbought nature of the ETF, but I wouldn’t mind owning it around $189, or roughly 5% 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 SPY at $189 a share – and collect an immediate $74 per contract. And no matter what happens, we get to keep that $74. If SPY stays above $189 – the $74 we collected is ours. But for the sake of understanding, we should examine the alternative – SPY closing below $189 by option expiration.
In that case, we’d keep the $74 and be forced to buy the ETF at $189 per share. In our case, we’d actually own the ETF for $188.26 per share – that’s the $189 strike price minus the $0.74 premium. That is 5.1% less than SPY’s current market price.
One way to think about it is that you’d receive $74 on a potential $3,780 investment. This works out to 1.96% on your money while you wait for the ETF to hit your price, and that is over 23 days. So, theoretically you could make this transaction almost 16 times over the course of the next year for a annual gain of 29.4%.
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.
If  you would like even more ideas regarding options trading, don’t forget to sign up for my free weekly options report, The Strike Price.

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