The Best Options “Crystal Ball” in the Markets

“Trust your gut.”

At some point in your life, you may have heard this from a parent, a teacher, a friend… you may have even told yourself this…

The idea being… you can never be wrong and can never lose when you trust your gut.

But here’s how this thinking can actually destroy you.

When it comes to trading options, trusting your gut can cost you everything.

And MAKING MONEY is my No. 1 goal.

Actually, I don’t believe in a trade unless I will – at the very least – DOUBLE my money.

But there’s a right way and a wrong way to do it.

The wrong way may reward you with some wins here and there, but will ultimately earn you a lifetime of losses.

The right way will spoil you with a lifetime of wealth.

And to get there, you simply need to be able to predict when a price stock is about to move.

Earlier this week, I gave you the tool for measuring the market trend – the Relative Strength Index (RSI).

Today, I’m going to show you how to use the RSI to predict where that trend is going – and when it’s about to change direction.

Let’s begin…

Conflict Can Be a Good Thing… and Lead to HUGE Profits

The developer of RIS, James J. Wilder, was a strong believer that divergence between the RSI and a stock’s price is a very strong indicator for a turning point or reversal for that stock.

While the RSI measures the trend, divergence tells you where that trend is going and predicts the moment when a stock will turn

It occurs when the price action of a stock (underlying asset) conflicts with the data that a technical indicator provides. In this case, we’re talking about a disagreement between the price action of a stock and the data that the RSI provides.

Now we know that the market can change at any time, but you can recognize and react the right way by knowing that there’s about to be a shift in the price action. This will lead to increased profitability in your trades.

There are two types of divergence that you will want to look for:

Bullish divergence:  When the stock price, the underlying asset, makes a lower low and the RSI makes a higher low. This gives indication momentum is gaining steam because the RSI doesn’t confirm the lower low.

Bearish divergence: When the stock price, the underlying asset, makes a higher high and the RSI makes a lower high. This gives indication momentum is losing steam because the RSI doesn’t confirm the higher high.

GMCR Chart

RSI Chart

No matter how long it took or takes, keep an eye out for the price and the RSI relationship. When you get a bullish move out of an oversold zone like in the visual example above, and it is backed up with a positive divergence, a chance for a higher move in price of the stock has a much greater chance of happening.

Now it’s important for me to point out that you may get multiple divergences in up and down trends. With that understanding, you should know this isn’t necessarily the best setup to use with the RSI. A better way to use the RSI is by looking for what is called failure swings.

Bank Higher Profits by Detecting a Trend Reversal

Wilder considered failure swings strong indications of an impending reversal as well. I reiterate, Failure Swings are based on the RSI itself NOT price action.

Failure swings occur when a technical indicator – the RSI – is in an overbought or oversold zone and signals that the current trend is weakening… and a reversal is highly probable.

They can provide higher reward opportunities because you will know what to do when the market is going the way you expected AND when it goes the complete opposite direction.

Like divergence, there are two types of failure swings:

Bullish Failure Swing: When the RSI comes out of the oversold zone by rising above the 30 line, retraces back to and holds at or above the 30 line and but then fails to reach the same level that it did before and turns downward again (forms an M pattern) then sees the RSI line break above its recent RSI high. Do not look for a divergence in price when this is forming as this signal is the focus, not price.

Bearish Failure Swing: When the RSI comes out of an overbought zone by crossing below the 80 line, retraces back up to and holds at or below the 80 line and but then fails to reach the same level that it did before and turns upward again (forms an M pattern) then sees the RSI line break below its recent RSI low. Do not look for divergence in price when this is forming as this signal is the focus, not price.

That failure to make the higher high or lower low is the failure swing, and indicates that an uptrend or a downtrend may be ending and reversing soon. Failure swings are solely focused on RSI and basically ignore the concept of positive or negative divergences.

That said, in the RSI screen for QUALCOMM Inc. (NASDAQ:QCOM) below, I have highlighted the following points to show you how the failure swing setup works – and what it looks like:

  1. The RSI is below the 30 line and coming out of the oversold zone by crossing above the 30 line.
  2. RSI comes back to and holds at the 30 line showing a bit of strength in the oscillator.
  3. The RSI line works its way above a recent RSI line high indicating a potential reversal to the upside.
QCOM Chart
RSI Chart 2

The RSI has lasted for over 30 years. In that time, much has been written about it and there have been many variations to it.

The RSI can indicate the strength of the existing trend, and traders look for it to show if a stock is oversold or overbought. They next key on whether that momentum that propelled them into these areas or zones is reversing course – and capitalize on these price moves.

As I said earlier, there’s a right way and a wrong way to capitalize on market trends.

As a trader AND a teacher, I always say that when setting up your options trades,  it’s best to know your expected price move in a stock and the time frame it can take to get there.

The RSI does not offer that, but you can look to initiate a bullish set up on a move out of the oversold zone and anticipate selling when it gets to an overbought reading to start.

The trick to using the RSI is recognizing failure swings and divergence and using that to enter high-income trades.

Subscribers to my Money Calendar can see the price expectancy and time frame of that price move. The RSI – as well as any number of similar momentum oscillators  could be a complement to it.

Here’s Your Trading Lesson Summary:

Earlier this week, I gave you the best momentum indicator to use to measure the trend of the market. Using the RSI can also help you predict where that trend is going and when it will shift direction. The two things to look for are:

  1. Bullish divergence and bearish divergence
  2. Bullish failure swings and bearish failure swings

Good Trading and Happy New Year!

Tom Gentile

3 Responses to “The Best Options “Crystal Ball” in the Markets”

  1. If there’s an ugly double bottom forming on the RSI (where the 1st leg dips noticeably below 30 while the 2nd leg stops at around 30 before prices bounce back up), does that always entail BOTH bullish divergence and bullish failure swings?

  2. Stanley G Tobin

    Hi Tom,
    Please take a look at Amazon and tell me if you see the bearish divergence in the RSI since the last earnings report in October. RSI is on a decided downward trajectory, didn’t make a new high from the last high at earnings report in July, even though stock price went higher. This looks like a more bearish probability here. I would love your thoughts if possible. Thank you. Stan

  3. Stanley G Tobin

    Sorry if this is redundant, just wanted to know Tom, if you see a bearish divergence like I do, in Amazon since the last earnings report in October. Higher stock price trend against a lower RSI trend. Many thanks, Stan Tobin

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