Option Investor
Trader's Corner

Love Broad Trading Swings? A Helpful Indicator

Printer friendly version

If you consider this market, at least since about the beginning of summer (what happened to the summer doldrums!?), to be a traders dream, you'd be RIGHT. But, and it's a large BUT, you have to be able to figure out the right entry and exit points. There has been a huge jump in volatility of course and their have been many broad trading swings; not ones where the S&P 500 (SPX) moves 20 or 30 points, but where there are 60 point price swings within a few days to at most 2-3 weeks. An option players dream as we have this remarkable period where some big price swings occur within these shorter time spans. Then another opportunity presents itself.

We all know how we can be right on market DIRECTION only to have a move be so slow that time premiums erode faster than underlying price changes. Of course here, I'm talking about buying options, not selling them; i.e., selling premium. I like the challenge and greater rewards of attempting to 'time' the market and I trade the indexes specifically as those following my weekly Index Trader well know. The technique of using 1-3 month hourly charts and the 21-period RSI is also useful for individual equities however.

One very useful way to chart this kind of (volatile) market we've been in recently is to use hourly charts of 30-60 days duration. This is a problem if you rely on charting sites that only provide 10 days of intraday data. Not a problem on charting applications like Q-charts, MetaStock, etc. Any feedback on this or other applications is appreciated (see my e-mail info at bottom). I've been using TradeStation software, with downloads of eSignal data for so long, that I can't always remember all functionality of other applications. Generally you can get an hourly chart of at least a few weeks duration in your own trading applications; the ones that you pay for mostly.

What I most value in an INDICATOR input on hourly charts is the Relative Strength Index (RSI) with a fibonacci setting of 21 ('length' = 21). Setting length to compute the RSI indicator for 21 periods of 'bars' takes the last 21-hourly closes and makes the RSI computation. RSI is basically a ratio of X number of UP closes versus X number of DOWN closes. X here is whatever the length setting you've chosen; e.g., 21.

Let me back up one second and say that I myself am looking for the occasional trade where I could realize 40-50 SPX points or more and be able realistically to set an exit point (absolutely necessary!) equal to one-third or less of those 40-50 or more points that I think could be realized on the move I'm getting in on. If I buy puts or calls at anything other than so-called overbought or oversold 'extremes' I run the risk of being 'stopped out'. I use the language of 'stops' here to mean exit points, whether my broker will take such an automatic order or not. Since I'm not talking about stocks or futures here, so one can't count on being able to enter an actual GTC (Good Til Canceled) or Day buy or sell stop order. I usually check prices morning, midday and near the end of the day, but sometimes can't do that either.

If a close is above/below my exit point, I'll liquidate the next day. In a period of high volatility this strategy carries the risk of exiting far above/below my exit 'trigger' point, but this is not all that common IF you ONLY enter calls or puts at market EXTREMES. The extremes are the overbought or oversold levels I'm going to discuss relative to an hourly chart using the 21-hour RSI only.

There are some specific levels I tend to use for the index I am looking at. There are slightly different levels that 'work' to show extremes depending on the Index. These work well on most of the major indexes, although not so well on the Russell 2000 (RUT) I've found. And, stocks have different levels that tend to define 'overbought' or 'oversold'. For this reason I like to follow a relatively low number of stocks so I can get to know these levels (the extremes); the ones that also have good-sized trading swings might be only 12-15 stocks in my trading universe.

I'll use 'line' or Close-only charts here; RSI is computed at the close of the hour or day or week anyway, although the last trade is temporarily considered to be the 'final' price for the bar or period we're in as far as an ongoing computation; when the period closes (e.g., hourly), the Close of 22 hours ago is dropped and the latest hourly Close is used in for a 21-bar Relative Strength Index (RSI) indicator.

In the chart below, you'll see that the RSI 'overbought' zone for the S&P 500 (SPX) hourly chart is between 62 and 65 or higher. The 'default' line for overbought is usually 70, but that's too high on the upside in general for the indexes. This is because the major stock indexes are broadly based and because rallies tend to be more gradual and slow than down swings; RSI only once reached a reading as high as 70 in the hourly chart seen below. On the downside, 'oversold' extremes tend to be seen when the 21-hour RSI registers between 27-30 or lower.

As you can see from the down red arrows, the RSI for the period shown (nearly 3 months), got into the overbought zone 5 times and into the oversold zone 3 times, one of which was way early in calling a bottom as noted. The rest of the 'extremes' were remarkably good in highlighting significant trading tops and bottoms. The key seems to be to wait ONLY for these key junctures. Hard to do in practice but this is why we should rely to some degree on technical formulas that take out some of the urge to jump into trades. For the timid of heart and I've certainly had MY moments, using a statistical device or formula like the one I'm describing here, can be the push that gets you off the high diving board.

Two more things:

1.) Sometimes, as was most apparent at the July top, the first RSI extreme is seen early and the index might chop around for some days more before a trend reversal. However, on a closing basis, you can also see that in July prices didn't go higher than the first RSI extreme so that a reasonable exit point over the market would not force you out BEFORE the move got underway. By the way, the sideways trend AND the overbought extreme was a double tip off that a top was forming.

2.) Unless you hope to wait to exit at the NEXT opposite extreme reading in the RSI (not advisable usually), don't rely on this indicator with this setting to tell you when to take profits on a trade. Points where the RSI approach the opposite extreme are helpful guideposts, but better to rely on price action, approaches to prior support or resistance, etc. to help time exits. Exceptions: it was buy puts at the early-August RSI extreme, exit puts and buy calls at the oversold extreme two weeks later! Not a long wait for me. I like trading the 2-3 week price swings rather than the 2-3 day ones; to each his own!

A further note on that oversold extreme indicated as 'early' on the SPX hourly chart above is a good example of why I always use a stop or close by exit point, so that I generally will only take a relatively small loss. I don't such tools as the RSI in a strictly 'mechanical' way but as a tool. A market in a steady and steep decline as was seen when the 21-hour RSI hit its first oversold reading is not necessarily a place that I would necessarily jump into calls.

Even if I had and didn't wait for, for example, signs of a key upside reversal such as was evident on 8/6, I would still be quite profitable in my option account overall; but not as much if I let a loss 'run'. By the way, the 21-hour RSI used with the S&P 100 (OEX) chart as seen next (below) did show an oversold extreme at the final mid-August bottom.

I don't have more to say about the use of the longer-term hourly chart with a 21-period RSI except that, as seen in the OEX hourly chart below, there are some variations even with closely related indexes, as to whether and when an RSI hourly extreme will be seen. The zone where oversold or overbought conditions occur also varies some. The OEX 21-hour RSI won't typically dip below 30, whereas SPX will. OEX can tend to register a bit higher readings, relative to SPX, on the upside however.

The hourly Nasdaq Composite (COMP) is my last chart. I always compare this chart to the Nasdaq 100 (NDX), as the index that I will actually trade, but rely most on the COMP readings in RSI as to input on the timing of trade entry. There were certainly some good opportunities suggested at some of the extremes seen in the chart below.

An interesting case is presented by the RSI extreme seen in COMP on the 8/24 hourly close around 2576. Another extreme has been seen at the 2584 hourly close today (not the daily close however). I wouldn't bet on COMP going a lot higher than seen today at least as suggested by the bearish price/RSI divergence; i.e., the hourly RSI reading today didn't 'confirm' the higher hourly closing relative high in the Composite. Stay tuned on that!

Please send any technical and Index-related questions for my answer or feedback to Click here to email Leigh Stevens support@optioninvestor.com with my name ('Leigh Stevens') in the Subject line.


Trader's Corner Archives