How many indicators do YOU use when trading? If it's "more than 5 or 10," it's way too many. Don't worry - it's a common problem.
Most traders use FAR too many technical indicators. Bull flags, bear flags, dojis, channel retracements and Fibonacci retracements are of the favorites.
Unfortunately, there is no “edge” when using technical indicators, particularly when using them in combination with one another.
New traders typically overwhelm themselves with the latest and greatest indicators.
And I've seen many traders move on to another indicator when it happens to fit their current market perspective.
It’s called "curve fitting" and it is extremely detrimental to successful long-term investing.
What's my advice? Keep it simple.
Early in my career I tried almost every indicator out there. It was like I was one of King Arthur's knights, on my quest to find the "holy grail" of indicators.
My search cost my tens of thousands in trading losses. And I'd like to help you avoid my mistake.
That's why I'm opening up this LIVE Options Trading Boot Camp. Click here for instant access.
To be successful, you must find a few indicators that fit your trading style. And then 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.
Now, I'm a bit unique. I'm 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.
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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.
What is my favorite indicator?
It's the Relative Strength Index (RSI).
RSI, developed by J. Welles Wilder, Jr., is an overbought/oversold oscillator that compares the performance of a stock or 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.
When an index reaches an extreme state, a short-term reversal is often 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 70.0
- Neutral – between 30.0 and 70.0
- 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. 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) and (5) days.
Let's look at a trade example.
The SPDR S&P 500 ETF (NYSE: SPY) is making new all-time highs.
Above, you can clearly see the “very overbought” and “overbought” state in the RSI (2) and RSI (5), respectively. While this does not occur often, when it does, I consider it an incredible opportunity to make a high-probability trade.
Knowing that the potential for a short-term pullback in SPY is imminent, you could employ a strategy known as a bear call spread. I don’t necessarily want to own SPY, but I wouldn’t mind trading here for the potential to make 26.6% over the next 38 days.
As an options trader, I love this scenario.
Extreme, short-term, overbought readings – like what we are currently witnessing in SPY and many of the major indexes – oftentimes lead to a reversion to the mean over the short term.
“Reversion to the mean” simply means that there is a greater chance of a short-term reprieve or “fade” in the price of the underlying stock. I like to think of it as the perfect opportunity to sell premium.
Right now, I’m bearish on SPY over the short term. I expect to see sideways-to-lower price action over the short term. But, I want to increase the odds of my bearish stance, given the extreme in mean reversion, by using this options strategy that allows me to have a margin of error just in case the short-term extremes continue.
In this case, a bear call spread – or vertical call spread – is the strategy of choice. It’s probably the most used strategy in my arsenal of options selling strategies.
To start, I have to decide which of several expiration cycle to choose. I prefer to choose an expiration cycle with roughly 25-50 days left.
For example’s sake, I’ll choose the October expiration cycle with 38 days left until expiration.
Once I decide which expiration cycle to use, I go straight to the probabilities.
I typically start with a short strike that has a probability of success around 75% or higher. The short strike defines my trade. It tells me how much I am going to collect in premium, plus my probability of success on the trade.
The October 253 strike has a 74.08% probability of success. Essentially, by choosing the 253 strike, I am content with the 74.08% probability that SPY will not push from its current price of $250.03 to $253 over the next 38 days.
Next, I need to choose a strike to buy. This defines my risk. I can decrease my risk exposure by choosing a strike that is closer to my short strike of 253 – say, the 254 strike. Or, I can choose a strike that is further away from my short strike of 253 – say, the 255 strike and pay less for the contract, thereby creating more premium in the trade.
I could sell the October 253 calls for roughly $0.78 and buy the October 255 calls for roughly $0.36. That equates to a credit of $0.42, or 26.6%.
Again, I keep it simple, very simple. Why would I attempt to create a complex options strategy when my strategy has a win ratio over 85%?
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 = boring and often that does not entice traders, but I am not here for excitement, I am here to provide a sound options strategy that makes people money over the long haul and that is exactly what the RSI indicator coupled with various options strategies (like bear call spreads) has succeeded in doing.