One of my favorite indicators is flashing a caution sign. It’s saying that a major U.S. market index is stretched to the upside.
Today, I’m going to give you a deep dive into how to use the indicator to spot and execute trades. But first, I want to give you a big picture view of the market and what that indicator is signaling…
That’s a chart of the S&P 500 along with the RSI indicator plotted below. As you can see, the 10-day RSI indicator is now above 80. That’s rare, it means markets are extremely overbought and traders need to be extra caution in this market.
I’m not suggesting the S&P 500 is going to crash tomorrow. But I agree with Roger Scott when he says traders need to be extra picky and stay nimble in this market.
That means limiting your exposure to only the very best setups and knowing when to take profit.
The RSI is great for getting a gauge on where the overall market is (in this case overbought)… but it can also be used to find swing trades on individual stocks.
To do that, I adjust the RSI indicator from 14 days to 10 days. By adjusting the period from 14 days to 10 days, the RSI becomes much more responsive and dynamic, these two qualities are very important for timing trades.
After adjusting the indicator from 14 periods to 10 periods, the next thing is to find stocks making a minimum 50-day high or low coupled with RSI reading above 80 (to trade to the short side) or below 20 (for long trades).
To give you a real-life example, I’m going to show you a bullish setup in Amazon (AMZN).
When I spotted this setup, amazon was making 50-day lows and the RSI was below 20.
Once you have that going for the trade, the next step is simple: monitor the stock.
You want to wait for the stock to make a new low BUT the RSI indicator must stay above the previous RSI reading.
In the case of Amazon, the first RSI signal was 20.00 even while the second RSI low bottomed out at 29.43 when prices hit a new low.
That’s called a bullish divergence.
The next step is to find the entry point…
You want the stock to rally above the high price that was made on the exact day the second low was reached before entering the trade. If the market trades lower than the second low the pattern is invalidated.
Unlike the moving average, the RSI is a leading indicator. These are swing trading indicators that project the future instead of relying on past price history.
To find your entry point, you simply wait for the stock to trade above the high that was made on the second down day. I typically give the stock about 5 trading days
Remember if during this 5 day period the market trades below the low that was made on the second bottom day the trade is invalidated.
In this example, Amazon rallied almost immediately after making the second low. Make sure you place your buy stop is right above the high that was made the day the second low was made.
I usually place my stop loss right below the second swing low.
And my profit target? That depends on the stock, the market and a few other factors. But in general, I try to target a level that makes sense relative to the amount I’m risking.
For example, if my stop is $10 below my entry price, I want to target a profit of at least $30-$40 per share. Which in the case of the Amazon trade above, would have delivered a nice gain.Could I have made more? Sure. But remember, you don’t go broke taking profit. I love you and you rock!
P.S. Roger Scott just released his top Lightning trade setups. Like I mentioned, these stocks tend to move pretty quickly, but it’s not too late for you to get in. Simply sign up here and you’ll get his latest alert in seconds.