(by Chris Rowe)
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.
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 RSI 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 RSI 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).