Volatility is finally back, thanks to Brexit, and as an options seller, we couldn’t ask for a better market environment. Over the next few weeks I’ll be discussing the benefits of a volatile market. But before I get to volatility I want to discuss the indicator I use for my high-probability options strategies. I often asked by readers what indicators I use, so…here you go.
“The trend is your friend but the fade is the ultimate wealth builder.” – Tom Sosnoff
One of the biggest mistakes I see new traders make 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 I know who want to follow bull flags, bear flags, candlestick patterns, channel retracements, Fibonacci retracements – the list goes on and on. They will try to 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 with 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. 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 to take advantage of sentiment and technical extremes on highly liquid ETFs.
So with that being said, I would like to share the most powerful technical indicator that I use in my proprietary model – the Relative Strength Index (RSI).
The 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, 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.
I love short-to-intermediate time frames for trades, because it means I don’t have to lock up lots of capital for a long time in order to profit. I can put a trade on, and in many cases, close it out within a week. That goes for winners and losers. I’m in and out. If I’m wrong, I’m not wrong for long, because I cut out almost immediately if the trade doesn’t pan out.
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.
I am a contrarian at heart. 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 know that in most cases, when an index reaches an extreme state a short-term reversal is imminent.
The following is the guideline for my “High-Probability Trades:”
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 15.0
Since I’m looking for extreme conditions, I almost always focus only on very overbought and very oversold conditions. When an asset hits more neutral levels, that’s an indication to close the trade out.
I use three different RSI time frames – the shorter the duration of the RSI, the more I want to see an extreme reading. The time frames are RSI (2), (3) and (5) days.
So now that you have the basics of the strategy, let me go over a recent example.
The following example is a trade that I recently closed in my portfolio.
Background: Russell 2000 (IWM) surged higher over the course of six trading days starting May. The surge lasted until May 20, at which time IWM pushed into a short-term “very overbought” extreme.
You can see the “overbought” state across both time frames in the chart below. When it a situation like this arises a high-probability trade should be taken into consideration.
Again, the RSI (2) and (5) readings below the chart clearly show that a short-term overbought extreme had been hit. At that time, I want to make sure my other proprietary indicators line up. If so, I will fade the move.
Remember that fading means placing a trade that opposes the current trend. In this case the move was higher; therefore I bought puts. (Remember, you make money buying puts if the underlying asset goes down.) Had IWM been at a short-term oversold extreme, I would have bought calls.
Here is the trade alert I sent out on May 26.
*The following are options with 51 days left until expiration.
Sell to open the IWM July 2016 118 calls (IWM160715C118)
Buy to open the IWM July 2016 120 calls (IWM160715C120) for roughly $0.39
Do not accept less than $0.35 credit to enter this trade. Enter this trade as a spread to avoid paying double commissions.
The goal of selling the IWM bear call (credit) spread is to have the underlying ETF, in this case IWM stay below the 118 strike through the July expiration in 51 days.
Here are the parameters for this trade:
- The Probability of Success – 78.58%
- The max return on the trade is the credit of $0.39 or 24.2% based on the required margin ($161) over the next 51 days.
- Break-even level – $118.39
- The maximum loss on the trade is $1.61 (remember – that’s really $161 per spread)
Again, with IWM moving into a short-term extreme on 5/20, I sold the July 118/120 vertical call spread for $0.39. This past Friday, the day after the Brexit announcement, I bought back the call spread for $0.20 for a gain of 14.5%.
Again, I keep it simple, very simple. Why would I attempt to create a complex options strategy when my strategy has a win ratio of more than 88% with an average return of more than 8% per month?
Why would I want to use an arsenal of gizmos and widgets, when I can use a simple tool like a hammer to get the job done?
Simple equals boring, and often that does not entice traders. But I am not here for excitement. I’m here to provide sound options strategies that make people money over the long haul. And that’s exactly what the RSI strategy succeeds in doing.
As always, please do not hesitate to email at [email protected] with any questions that you might have.