The RSI Says It’s Time to Buy (IWM, SPY)

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We might just be at a market bottom after all.

Relative Strength Index (RSI) is a technical analysis indicator that measures overbought and oversold levels in stocks, funds and indices alike, and for the past five years, RSI has accurately gauged market bottoms for small- and large-cap stock indices.

Good news for us, then. After declining by slightly less than 14% from its peak in early July at $120.18 per share to a trough of $103.54 per share in October, the iShares Russell 2000 ETF (IWM) found a base just as its RSI hit oversold territory.

Historically, market bottoms are V-shaped as opposed to U-shaped, meaning that prices decline rapidly and snap back quickly, forming a pattern that looks more like a V as opposed to a smooth bottom that forms a pattern that looks like a U. By analyzing price action via the RSI, you can estimate rebounds that are V-shaped.

The RSI was developed by J. Welles Wilder, in an effort to measure the speed and change of price movements. RSI oscillates between zero and 100. According to Wilder, the RSI is overbought when the index produces a reading above 70 and considered oversold when the index produces a reading below 30.

IWM
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Currently, the IWM’s RSI is below 30 — just the fifth time this has happened in the past five years.

For this analysis, I measured how far the IWM increased once it crossed into oversold territory relative to the next price peak for the ETF and a subsequent 5% correction. So if IWM increased from $100 to $110 and then decreased to $104, I would only measure the move from $100 to $110 and not any subsequent moves. In all four instances, the IWM increased by an average of 15%.

The SPDR S&P 500 ETF (SPY) notched a RSI reading below 30 in mid-October, and again, oversold readings under 30 have occurred just a handful of times over the past five years. In each circumstance, the net return prior to a 5% pullback in the price of the SPY was positive for an average gain on the SPY over 12.5%.

So how can you take advantage of the recent RSI readings in both the IWM and the SPY?

Aggressive investors could simply buy either or both ETFs. However, investors who are looking for a more conservative approach could consider covered calls, which can protect against further downward price pressure, while taking advantage of high levels of current implied volatility.

A covered call strategy is one where you purchase a stock or ETF, and simultaneously sell a call on that stock or ETF with a higher strike price. For instance, you could buy the SPY at $189.12 and simultaneously sell the Dec $195 calls for $2.21. That $2.21 in premium protects you down to a breakeven price of $187 ($189.12-$2.21) if the price of the SPY falls.

The downside to a covered call is that you give up some of your upside, as the buyer of the call will take your covered shares should the SPY move above $195 on the expiration date.

As of this writing, David Becker did not hold a position in any of the aforementioned securities.

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Article printed from InvestorPlace Media, https://investorplace.com/2014/10/iwm-spy-rsi-oversold/.

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