When you’re entering a stock or option position, not only is it a challenge to find the right one to trade, but also the best time to buy.
There are lots of indicators out there that can tell you when it’s time to buy, but once you’ve initiated a position, you’ve got an equally difficult decision in front of you: When do you cash in or cut bait?
In other words, how do you know when it’s time to sell?
Everyone, including the top technical analysts on earth, agrees that picking the right time to close a position is much harder than picking the right time to buy, so you’re not alone.
So I’m going to share a signal with you that you can use to help you decide when to exit a position.
Looking for a Sign? Try the Relative Strength Index
The Relative Strength Index (RSI) was developed by J. Welles Wilder Jr. in 1978, and is one of the most helpful, widely used indicators employed by chartists today.
First, it is very important that you don’t get this confused with other types of relative strength indicators. This does not have to do with relative strength when compared to the market or other sectors. (Learn how to determine the relative strength of a sector.)
This momentum oscillator is related to the stock’s current strength relative to its own recent strength.
To oversimplify, the relative strength of a stock is the average price change of the advancing periods with the average change of the declining periods each day or week, etc. The number is then “smoothed” by using the previous period’s average gain and average loss.
When the average gain is greater than the average loss, the RSI rises. And when the average loss is greater than the average gain, the RSI declines.
Taking ‘Stock’ in the Results
You can use the average relative strength of any number of time periods (i.e., any number of weeks, days, months, etc.), but Wilder recommends using time periods of 14.
The shorter the time periods used, the more volatile (or sensitive) the reading will be. Depending on your time frame/objectives, you may choose to increase the number of time periods (whether it be days, weeks, months, etc.), as shorter readings are more prone to false signals.
This number ranges from 0 to 100 and, similar to the NYSE Bullish Percent Index, a reading of more than 70 indicates overbought territory, and below 30 indicates oversold territory.
If the Relative Strength Index rises from below to above 30, it is considered bullish for the underlying stock, and if the RSI falls from above to below 70, it is a bearish signal.
You should also note that, while you can use this leading indicator to find exit points, like when your stock appears overbought while in an uptrend, it works even better when you first identify the current trend and then find the extreme signal for entry points.
The RSI in Action
For example, you could find a confirmed uptrend, and then use the RSI to find the oversold levels within the uptrend as an entry point. Conversely, you could use it with a stock in a confirmed downtrend to find the overbought point to initiate a short sale.
Also noteworthy is that the Relative Strength Index reading of 50 is considered to be the “centerline” (a key point in the RSI). A reading above 50 indicates that average gains are higher than average losses, and a reading below 50 indicates the opposite (and, basically, that the bears are winning).
Why is this noteworthy? Because many traders consider the RSI crossing over the 50 “centerline” to be an extra confirmation of what the Relative Strength Index seems to be telling you. At this point, it would help to see this on a chart.
Making Sense of Sun’s Signals
Below is a chart of Sun Microsystems, back when it was a $60 stock. (It has since changed tickers and dropped 50 points.)
In this example, though, you’ll notice that the RSI is highlighted in red in the overbought territory (above 70), and highlighted in green in the oversold territory (below 30).
Now remember, stocks can stay overbought for a long time. So, while a reading above 70 is considered overbought, it isn’t necessarily a sell signal until the Relative Strength Index moves back below 70.
There are different clues here that could have told you when it was time to sell the stock, and look for something with less risk.
First, you can see that from February to March, even though we saw Sun Micro trade higher, the RSI moved lower. This is what we call “negative divergence.”
This negative divergence came after the Relative Strength Index was slightly above 70 (overbought territory). Negative divergence showed that the momentum was slowing even though the stock was moving higher.
Higher moves in a stock’s price that are not confirmed by the momentum (in this case, RSI) are likely to be followed by at least a slight decline in the stock.
Now, you might be staring at this chart and saying to yourself, “Hey, the RSI had already reversed from an even higher point in December, to below 70.” This is true. But this is typical when a stock takes a breather and trades sideways.
Usually, when a stock is overbought, either it needs to correct by moving lower, or else it needs to trade flat, which also allows the average price to catch up to the current price. When you think about what the Relative Strength Index actually is, this makes perfect sense.
Notice that this is what occurred in that same time period (December to February). That is why it’s important to not only look at the indicator, but to compare this to what the stock is doing. A reading of 50 basically means the momentum is flat.
So again, when a stock stops trading higher, and only trades flat, it is normal for the RSI to move to the centerline.
Another confirmation that the Relative Strength Index reading was not signaling a sell was that the support level (blue line), or 50-day exponential moving average (EMA), was not violated. Sure, at this point, you’d want to be extra-cautious, but this is not the same as negative divergence. (Learn how to Keep Your Portfolio Moving With Moving Averages.)
After reversing down from overbought territory, the negative divergence did occur, followed by a break in Sun Micro’s support level in April, as well as the 50-day EMA. Noticing this and acting could have gotten you out at $45 before the drop to $35.
Now look on the right of the chart where the stock topped out at $65. The RSI dropped from above 70 to below 70 and almost immediately dropped below 50. If that wasn’t enough for you, the RSI dropped through 50 a second time. And even though the stock seemed to try to bounce back up off of the 50-day EMA, the RSI dropped further down. This was another small (unmarked) negative divergence.
This told me to get out above $55 before yet another drop to $35 and, eventually, to the $2 range!
Below is a one-year chart of Motorola, before it became the $6 stock that it is today.
Again, here you can see that the RSI was in overbought territory, and then reversed back down below 70.
You can also see the negative divergence from August to September, and then again from mid-September to October.
If these signals weren’t enough to spook you, the RSI confirmed its sell signal by crossing over the centerline (50), indicating that the bears were definitely in control. If you didn’t listen to the RSI when the stock was trading up above $25, you should definitely have gotten out of the stock when the support level was broken, and the stock moved to $24.
You might have been upset that you missed selling at $25, but it would have been way less painful to lose a point then to wait for the stock to start skidding into the single digits.
Suncor Shares Run out of Energy
Below is a chart of Suncor.
First take a look at the RSI buy signal in March. You could have bought the stock at $68 per share (or the call options, which had traded up several hundred percent).
As you can see, after being slightly below 30, the RSI moved higher (showing a higher low) while the stock revisited its same low around $67.80.
This was a “positive divergence” after the RSI saw an upside reversal from $30. If that weren’t enough for you to buy the stock (a double-bottom, a positive divergence and a reversal from the $30 level), you will notice that, after the RSI buy signal, the RSI crossed over the centerline as the stock crossed $70, showing that the bulls were clearly in control.
Now, what if you bought it at $76 in late March because you saw it gap up above its $75 resistance? That move paid off for many who took that route, as the stock moved above $82. But let’s look at it more closely.
A ‘Flat’-out Sell Signal
I highlighted in yellow when the stock essentially traded flat. Usually the RSI would move down near 50 when the stock trades flat (remember?).
Even though the RSI, at that point, moved above 70 — and even slightly below 70 — it was no big deal, as it would be normal for the RSI to move even lower when Suncor traded sideways.
The RSI moved even further above 70 to almost 80. What do you think happened next?
That move served as a red flag. But remember, it isn’t a sell signal until the RSI drops below 70. When that happens, you want to look for other clues to confirm what the RSI is saying.
* Does the RSI move down, but the stock trades sideways? If so, heed the warning a bit less.
* Does the RSI drop further and cross under 50? If so, then you have your sell confirmation.
Either way, the stock was overbought there, based on the RSI.
When you see an overbought stock, it doesn’t automatically mean you should run out and short it. But if you own a stock and see these indicators, you know what you will need to do.
Go after money doublers with every trade you make! Download your FREE copy of The Options Trader’s Guide to Technical Analysis today.