Buy and Sell Indicators You Need to Know

In my last column, I showed you how to determine buy and sell points using a primary indicator such as the divergences on the MACD. Today, I'd like to cover how to use secondary indicators, RSI and stochastics, to help you know when it's time to rid yourself of those longs or shorts.

RSI, or the relative strength index, simply shows the power behind a stock's advance or decline. It tells you when the power behind that move is getting used up, or when, if a stock is declining, the energy to get that stock lower has also run its course.

Stochastics is a complicated formula showing how a stock closes against itself over a given time period, but the relevance is that it, too, will tell you when a stock has used up its energy on both the long and short side of the equation. It signals when a stock is about to stop moving in one direction and turn around, at least for the short term.

It is extremely important to pay attention to these rules in all time frames, but especially if you're a short- to mid-term trader. If you're trading for the long term, your focus is more on the divergences alone. But for the majority of short-term and mid-term traders, this is an essential element in knowing how to trade properly and protect the gains you worked so hard to obtain. Ignoring them can wipe out a good trade in a matter of days, if not sooner.

Although RSI and stochastics are basic ways to understand the energy being used up by any stock or index, they do work a little differently, depending on the time frame you're looking at. For instance, the 60-minute chart, which is very near-term in nature, reacts faster to topping or bottoming out when it gets overbought or oversold on either indicator. The daily may, and I say may, react a little more slowly to being overbought or oversold on these.

Ultimately, however, they will play out, so you really need to understand how to follow these guidelines. Sure, you may sell a bit early, as timing anything perfectly is very difficult. However, in the end you will be able to protect the majority of your gains if you obey the simple laws of overbought or oversold.

The most interesting rule to follow when looking at stochastics and RSI, in tandem, is that if both are confirming each other, meaning both are overbought or oversold at the same time, then the reversal of the recent primary move is likely to happen more quickly and with more ferocity. In addition, the longer a stock or an index stays overbought or oversold, the greater the reversal will be.

You'll often be amazed at how long RSI and stochastics can stay overbought or oversold and wonder, "Why did I get out of my position so soon?" The problem is that once the reversal commences, the harder and faster a stock or index will fall, and you'll end up thinking it was all right get out after all. Remembering that the market is largely about emotion, you'll have to force yourself to make peace once the overbought or oversold condition is created.

Now let's discuss what levels need to be obtained for any stock or index to say it's overbought or oversold according to stochastics or RSI. Stochastics work on a 0-to-100 scale. Zero is extremely oversold, while 100 is extremely overbought. Anything 20 or below is oversold. Anything 80 or above is overbought.

Click here for larger image.

Source:

If a stock is strong, 80 won't usually do the trick to say it's overbought. It will usually need 90 or more. The same is true on the oversold side. Twenty is oversold, but it'll usually need 10 or less to trigger the move back up.

Click here for larger image.

Source:

On RSI, a scale of 30 to 70 is used, but extreme readings near 20 on a drop can occur, as can moves up to 85 or 90. Anything 30 or below is a warning sign that a reversal is coming back to the upside, while any print of 70 or above tells you a move lower is coming.

Remember that these are short-term indicators that do not tell you what's coming in the longer term, but they can help you protect valuable gains whether you are short or long any stock in the market.

---

Jack Steiman is president of TheInformedTrader.com, for which he also conducts live seminars, and Steiman New Research Group, LLC. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Steiman appreciates your feedback; click here to send him an email.