The Most Important Tool in My Trading Toolbox

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“The trend is your friend but the fade is the ultimate wealth builder.” – Tom Sosnofftechnical indicator
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 technical indicators to make themselves look impressive. They think they have found the holy grail of indicators.
In reality, most are horrible traders over the long term. They overwhelm themselves with the latest and greatest indicators, only to move on to another indicator that happens to fit their current market perspective.

Keep It Simple

I keep it super simple when I trade. I pick one technical indicator 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.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. That 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.
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 was developed by J. Welles Wilder, Jr.  It 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.

How the Technical Indicator Works

Basically, RSI allows me to gauge the probability of a short- to intermediate-term reversal. This technical indicator 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. It means I don’t have to lock up lots of capital for a long time to profit. I can put a trade on and often close it out within a week to three weeks. That goes for winners and losers.
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 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 20.0

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.
If you would like to know more about how I use RSI and my current views on the market, take a look at my educational video in Thursday’s video edition of the Strike Price.
 

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