The Tycoon Report

What To Do When You're Bullish/Neutral

Thursday, April 26, 2007 | Chris Rowe


Thanks again, Tycoons!  I love your feedback. 

This week I'll give you a very quick review of "RSI" and, of course, the options strategy for when you think your stock may be overbought.

If you didn't know, two Thursdays ago, I wrote an article titled "How to Not Jump the Gun on a Trade", and last Thursday, an article titled "How to Sell at the Right Time."

If you like today's article, then you'll probably want to check 'em out.

First: Let me say that some of you showed disappointment  that you had already deleted the first article form your e-mail box, and wish you could review it.  

A Side Note: To access the old article ("How to Sell at the Right Time",) you could have just clicked on the link or gone to The Tycoon Report website.  When I say, "Click on the link," what I'm referring to is when a word is highlighted, you can click on it and it will take you elsewhere.  For example, you can see last week's article by clicking here.

Back to the RSI indicator and the options strategy ...

First of all, I have received lots of feedback (just like I said I would) asking me to talk about all of these other indicators (besides RSI.)  This goes to the heart of the problem of the education process.  What do I mean?  Well, everyone wants to know everything all at once.  And the fact is that understanding different indicators is important, but having a strong understanding of one before moving on to the next is equally as important.

If you don't spend some quality time learning one indicator at a time, you'll forget some of the most important aspects of it, and then you will partially understand 3-5 indicators instead of knowing this one well before moving on.

For instance, as we discussed last week, when the average stock's RSI is over 70, it is considered overbought.  How many of you remember that THAT isn't a reason to sell?  How many of you remember that the sell signal is not given until the RSI moves from over 70 to under 70?

What you need to do now, is spend some time staring at charts every single day.  Get a list of stocks.  It doesn't matter what list of stocks, as long as there are at least 30-50-100 stocks, and look at their charts along with the RSI tool.  (You can go to www.bigcharts.com which offers the RSI tool for free.)

Sound like a drag?  I do this every day.  If you want to be a better trader, then it's well worth the time.  (Think of all of the money you'll save!)

Again, I can spend a lot more time going into further detail about RSI and all of the other indicators that I use.  But I have to keep this short and sweet. 

First , two brief additions to last week's lesson on RSI that I either left out, or didn't stress enough ...

1) Different strokes for different ... um, stocks ...

When using RSI, the rule of thumb is that the stock is overbought or oversold when over 70 or under 30 respectively.  But keep in mind that all stocks (or indices) are different.  It is helpful, when using RSI to gauge whether your stock is overbought or oversold by looking at the stock's history vs. its historical RSI.

You may find by looking at the historical charts, that a stock (or index) was actually oversold the last 5 or 10 times that the RSI was at 35 (not 30.)  Maybe the stock (or index) was overbought the last 10 times it was at 65 (not 70.) 

Believe me, most stocks will fall under the rule of thumb (30 and 70,) but you should have a good feel for what you are trading to get a clearer picture of what the RSI indicator is telling you.

2) Zoom in and zoom out. When using any indicators, on any charts, it pays to look at your shorter-term picture, and then zoom out at the longer term picture because RSI signals prove more reliable when the shorter-term signals are confirmed by longer-term trends in the stock market and longer-term RSI patterns.  So check out not only the daily chart with RSI, but the weekly and monthly charts with RSI.

As a side note: Keep in mind that when we switch from the daily chart to the weekly chart, each bar that used to represent a day, now represents a week.  So you can have a 5-year daily chart, a 5-year weekly chart, or a 5-year monthly chart.  Sometimes the novice gets confused here, and tends to call a 1-month (time frame) chart, a "monthly (time period) chart", and so on.

Check it out:

Below is the Nasdaq Composite: 1-year daily chart - 5-year weekly chart - and 5-year monthly chart.  When you compare the three time periods, you will see why I am skeptical about this recent stock market rally.  And although it pays to be skeptical, we must not fight the trend, which is currently up...

As you will see, the RSI becomes much less volatile, when we look at longer term time periods (daily, weekly or monthly.) 

First look at the 1-year daily chart:


On the left side, you can see (marked in green) a very noticeable positive divergence (lower prices unconfirmed by RSI patterns) signaling a bottom in last year's (May-June 06) correction.  Then you can see (marked in red) a clear negative divergence,  (the failure of momentum to confirm the price gain,) indicating a bull market that's losing momentum. 

Now let's compare the recent correction (February 2007) to last year's correction (May - June 2006) and let's also compare this year's correction on the daily charts, to the weekly and monthly charts.

Below is the 5-year weekly chart.


As you can see (marked in blue,) the weekly chart agrees with the daily chart that last year's (May-June 06) correction (marked in blue) was in oversold territory. 

But the daily and weekly RSI disagree on February 07's correction.  Although the daily RSI says that we were oversold in February, it appears not to have been considered oversold from the longer-term (weekly RSI) perspective.  In fact, the weekly reading only brought the RSI down to about 50 (marked in blue.)

You can also see from this longer term perspective that this weekly RSI reading agrees with the daily RSI reading that we were overbought leading up to the recent (February) correction. 

A Side Note: The chart above is a prime example of why you should look at the history of the stock or index that you are comparing its RSI to.  After the 2002-2003 recovery of the bear market, the RSI never made it below the 30 mark, but did make it to about 35, or just under 40 on all three corrections (late summer '04, early '05, mid '06.)

During a strong bullish trend, the RSI may not make it as low as 30.  If you see a confirmed bullish trend, and you are using RSI to buy on the dips, then depending on the stock or index, you might consider a higher parameter to indicate oversold territory.  Conversely, during a strong bearish trend the RSI may not make it as high as 70.  Depending on the nature of the stock or index, when you see a confirmed bearish trend, you might consider a lower parameter to indicate over-bought territory.  Again, it helps to look at the index or stock's historical price vs RSI action.

Finally, the 5-year monthly chart:


As you can see this RSI reading has minimal volatility.  The larger the time periods (hourly, daily, weekly, monthly,) the less volatile you can expect the RSI to be.

On this monthly chart, when the market was oversold, the reading was around 50 every time.  From a long-term investor's standpoint, the RSI reading was close to the oversold 30 reading back at the bear market bottom in 2002.

If you were a long-term investor, you may have bought like crazy in 2002, and not looked back since.  As a matter of fact, the recent February correction was hardly a blip on the monthly RSI reading.  But what you can clearly see on the monthly RSI, is that we are deeper in overbought territory than we have been at any point in the last five years (RSI at about 70.)

So here's what we've learned:

Were we oversold in June 2006?

Daily RSI      - Yes
Weekly RSI  - Yes
Monthly RSI - Yes

Were we overbought in February of 2007?

Daily RSI      - Yes
Weekly RSI  - Yes
Monthly RSI - Yes

Did the correction of February 2007 put us in oversold territory?

Daily RSI      - Yes
Weekly RSI  - No
Monthly RSI - No

Are we overbought today?

Daily RSI      - No
Weekly RSI  - No
Monthly RSI - Yes

The lesson?

RSI and other indicators may not give us the winning numbers to the lottery.  They can even give us false signals, or conflicting signals.  But at least this and other indicators give us a clearer picture of what is really happening with the market.  Conflicting signals from different time periods should be viewed as a red flag, or a reason for skepticism.  But when different time periods all say the same thing, it makes the signal MUCH stronger.

Remember, just because a market is overbought doesn't mean it's a time to sell.  The sell signal is given when the RSI moved from above 70 to below 70.  Look for positive or negative divergences as clues, and as precursor to an even stronger RSI signal.

Okay, folks, it's time for the options strategy for when your stock seems overbought, but you are still not ready to sell it. 

You're gonna kill me when you hear what it is.  Just understand that the reason for my focusing on this is 1/3 to talk about the actual strategy, and 2/3 to answer the question: "Which call option is the right one to sell?"

Bonus Strategy: Covered Calls (Even if you're familiar with covered calls, make sure you know the following...)

This is a strategy that many average stock traders understand clearly, but I find that many people who know the principle don't know the most effective way to use it.

Here's the key:

When you sell any option to open (in an effort to collect a premium,) you should almost always sell the "front month" (the month with the closest expiration day) and you should ALWAYS sell the closest "strike price" (the price that you are agreeing on that a future transaction may (or may not) take place..)

I'll backtrack (only briefly) for those of you who don't understand what I'm talking about here.  I'm not going to explain the covered call strategy, but if you want to read more about the mechanics of the strategy, read my article "Become the Casino with this simple options strategy" ... by clicking on that highlighted link (remember?)

I'll keep it as simple as possible here, but this is going to be easier to understand if you already understand the basic concept...  

When you own a stock, and your outlook changes from bullish, to bullish/neutral, it makes sense to sell covered calls.  Essentially, you will be selling someone the right to buy your stock at a certain price.  What you are doing in this case is selling a "call option".  (The buyer/owner of the call has the right to buy a stock at a specified price from the seller of the call, and the seller of the call has the obligation to sell a stock at a specified price to the owner of the call.  Eventually the option expires, and it basically ceases to exist.)

Okay, so the point, again, is to sell the front month (in most cases,) and the closest strike always.  The reason I say the front month in "most cases" is that if the next options expiration is within a few days, it may not make sense to sell a call as it may have little to no time value, and therefore not worth it.  In this case, you would sell the call expiring in the following month.  You basically want to sell the call that expires within 30-45 days.

The reason we pick the front month, is because as we approach the expiration day, the option loses value at a rapid, accelerating rate.  Therefore, the month with the closest expiration will deteriorate the fastest, which is good for the seller of the call.  The reason we choose to sell the option with the strike price which is closest to the stock's price is because that is the option that will have the most time value (extrinsic value,) which is the part of the option that is affected by time decay (the deterioration of the value of an option as a result of time passing.)

So again, by choosing to sell the front month call with the closest strike price, we are shorting the call which has the most time value, and is going to lose value at the fastest rate.  If you are selling calls any other way, you are doing it the incorrect way and in a way that is not the most beneficial to your wallet.

Since I used Suncor Energy in an example last week, I'll use it today.  Here's the 6-month daily chart on Suncor.

As a side note:  I mentioned last week when Suncor was between $81 and $82, that the stock was in overbought territory, since the RSI was near 80.  Since then, it had reversed down below 70 which is an RSI sell signal.  You can see that the stock dipped down a little bit, but it is essentially trading flat.  If the RSI moves down to 50, while SU trades in a tight range (essentially flat,) this would be normal (not bearish.)  The stock may eventually move up or down, but either way, it was in overbought territory.


Anyway, let's suppose that we liked the stock, and because it gapped up from $79 - $80 on high volume (typically a bullish sign,) and even slightly broke its resistance at $82.00 (another bullish sign,) we wanted to hold the stock.  But then again, the stock only moved slightly above the $82.00 resistance (set back in December,) and the RSI did say sell.  We're torn between hold, and sell.  We respect the RSI signal, but our gut says it's not time to sell.

So what would I do?

First I would pull up an option chain to look at what options are offered.  I already know that the call option that I sell, to open the transaction, will be whichever one has a strike price which is closest to the stock's current price. 

But what month should I pick?

To understand the logic of my decision you have to first understand the difference between intrinsic value and extrinsic value.  Intrinsic value is the amount by which the option is in-the-money, and the extrinsic value is the remainder of the call options value.

The extrinsic value (time value) of an option deteriorates as time passes (or when the stock's price causes the option to move more in-the-money.) So if a call option is at $3.00, and we figure out that the intrinsic value is $1.20, then we know that the remaining $1.80 is considered extrinsic value (aka. "time value.")

To keep a long story short,

Only the time value (extrinsic value) portion of the call option deteriorates when time passes.


As you can see, when I wrote this article, the stock was at $80.82.  So the closest strike price to $80.82 is $80 (highlighted in yellow.) 

Remember, when we sell a covered call, we want to sell the one with the most time value (extrinsic value.)

Let's compare the three call options with the closest strike price.

May 75 trades at $6.40.

In-the-money by $5.82. (Stock price $80.82 - strike price $75 = $5.82 intrinsic value which is not affected by time decay.) 

Therefore, out of the $6.40 that we will receive, only 58 cents is time value (extrinsic value) and is affected by time decay. ($6.40 option price - $5.82 intrinsic value = $0.58 intrinsic value)

May 80 trades at $2.75.

In-the-money by 82 cents. (Stock price $80.82 - strike price $80 = 82 cents of intrinsic value which is not affected by time decay.) 

Therefore, out of the $2.75 that we will receive, $1.93 is time value (extrinsic value) and is affected by time decay.  ($2.75 option price - $0.82 intrinsic value = $1.93 cents)

May 85 trades at $0.75.

This is not in the money at all.  It's out of the money because the strike price is higher than the stock price.  The entire 75 cents is time value (extrinsic value.)

Therefore out of the 75 cents that we will receive, 75 cents is time value (extrinsic value) and is affected by time decay.

Obviously, the May 80, the call with the closest strike price has the most time value and should therefore always be the call that you sell.

Extra tip before I go eat my wife's amazing cooking:  If Suncor were to trade higher, although the call option would move higher along with the stock, this, too, would cause the extrinsic value in the call option to decline. 

When you short something (like a stock or a call option,) you profit when it moves down, and lose money when it trades up.

So while you are short a call that is moving higher (and is therefore considered a loss on the option position,) you will also own the stock which trades higher, which is a gain on the stock side of the trade.  In this case, the stock will gain more than the option position would lose, which makes the entire position a net gain.

So what would the best move be, in the case that Suncor were to trade up to $85.00?  It would be to simultaneously buy back that May 80 call, and then sell the May 85 call (or, if we were very close to the May expiration day, I would sell the June 85 call.)

This way you will benefit once again from the deterioration of the call option with the most extrinsic value.

These articles are getting to be longer and longer each week.  I promise to shorten them from now on, folks.  I hope I helped your stock account today.  And remember, click below to tell me what you think, as I read everyone's feedback!

(I base much of what I write on the feedback and ratings.)


“Profit from the Trend”

Chris Rowe
Chief Investment Officer
The Trend Rider