An Intro to Options, MACD, and RSI

Before we dazzle you with our unparalleled analytical acumen and uproarious wit, we’ve got to shut down a very nice trade that’s returned a good wad of loot since we opened it back in late September.

The letter was called Repent, Sinners – Turn Back or Face the Unspeakable, and there we spoke of the virtues of guns and all they can accomplish – in the right hands, of course. We were targeting Sturm Ruger (NYSE:RGR) a company with a long history and whose stock had been on the rise and represented, in our view, an investment of the highest caliber.

It was also beneficial, we believed, that Ruger had one of the highest short interest ratios of any stock on the NYSE, and that before long all the naysayers would have to take cover when ballistic sales numbers went boom.

And Cover They Did

A look at the chart of RGR for the last six months shows that the timing of our trade was anything but a bullseye.

We expected a turnaround in the company’s fortunes and a significant pop from the short covering to occur last quarter.

But it didn’t.

Have a look –

RGR Chart

The pop transpired last week, after the company posted outsized earnings on the quarter, handily beating analysts’ guesses with a $0.53 profit figure (the consensus estimate was $0.42).

All told, the rise off the December bottom was 59%. That’s a stunning climb, most of which was garnered with the help of short covering over the last week.

What’s worrisome, however, is that the pop carried the RSI indicator above the ‘overbought’ 80 level. This read tells chartists that it could be stalled here for a while (in green, above). The massive one day surge in volume (in red) also speaks to the short covering episode we predicted – five times average daily volume likely included a good number of shorts.

Additionally, we see the move carried as far as the longer term 274 day moving average (orange line), a standard point of resistance. That could suppress the number of buyers entering the fray.

All things considered, we feel it prudent to rejoice that we emerged with a profit from this one. The original recommendation was for the purchase of a “speculative deep-in-the-money April 35 CALL on RGR… for $14.00.”

Today, she goes for $1550, and that’s a tidy profit for five months…

Not bad.

Cash Out, and Listen Up

We’re going to continue today with our options trading seminar series, offering readers a look at what we believe are the most reliable technical indicators for traders.

Now, what, you may ask does technical analysis have to do with options trading?

And we say –

Gasp

Why, everything!

Options trading is a relatively short term enterprise. Each trade may be open for as little as a week or two (or less), or as long as five to six months. These are optimal parameters. And because we aim to see results over such a short time horizon, we have to be sure our timing is on. Betting that Microsoft is going to rise, and then waiting for a year and a half before it does, is no way to profit in the options game. Technical analysis helps us avoid that. It gives us a leg up on the crowd by assisting us to pinpoint turns in the general market and in specific stocks with a greater degree of accuracy.

Today, our lesson begins with…

RSI and MACD

So much for introductions.

We’re going to highlight the RSI and MACD indicators, which we believe are the most reliable and useful of all the devices in a chartist’s tool box. We’re going to skip over the technicalities of how they’re computed in favor of how they’re used. If we have time in a future letter, we’ll delve into the mathematics underlying them and how they can be customized.

The Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD) indicators can often be employed together to determine intermediate term changes in a security’s direction.

Look here –

What RSI and MACD Are

Generally speaking, RSI will lead MACD higher and lower. When a cross above the key midway ‘waterline’ occurs for RSI, and MACD subsequently confirms (as seen in the example above), this is a strong bullish indication.

And the opposite is true when they submerge below their waterlines.

Here is what happened to the above stock after MACD confirmed RSI’s surface above her waterline –

XHB Example

A simple bet on these two indicators would have garnered a 20% return on a straight stock purchase (in blue). On an options trade, many times more.

There are two more ways RSI and MACD can be employed –

1) Via ‘oversold’ and ‘overbought’ RSI reads, which are reliable turning point indicators (see below), and
2) Via ‘divergence’ between RSI and MACD on the one hand and price on the other.

Take a look here –

How To Read MACD and RSI

The Select Sector SPDR Energy ETF (NYSE:XLE) illustrates well both of the above points.

As crude oil declined steeply for some six months, the oil producers (represented by XLE) also tumbled. That is, until a sub-20, oversold read (in red) was struck, and both RSI and MACD began trending higher.

Taken together, those indications let us know that a turnaround was underway. It indicated that the selling momentum was abating, and that a bullish entry point was up-and-coming.

Indeed, by mid-February, when both RSI and MACD surfaced above their respective waterlines a very reasonable buy signal could be divined.

Next on the Block: Volume, Moving Averages, and Price Patterns

In our next few letters, we’ll be returning to discuss several other reliable indicators. As to other popular technical indicators – we’re often asked if they’re useful, too. People tell us they couldn’t survive, for example, without Stochastics or On Balance Volume or Bollinger Bands in their studies,.

To that we say simply – bully for you.

All our tests of those indicators over the last three decades have shown they have little predictive value. While we may glance at one or two of them on occasion, it’s only to get secondary confirmation for one of our primary tools. As we frequently say, they’re alright for sharpening, but not for cutting.

Stay tuned.

Don’t miss another RGR Winner.

Get Started Trading Options And Hitting Big.

Don’t Miss Another Opportunity – Click Here To Subscribe And Get Hugh’s Picks Weekly

Wall Street Elite recommends you consider closing your RGR CALLs for $16.00, as detailed above.

With kind regards,

Hugh L. O’Haynew

See what people are saying...

  1. Jesper Markenstam

    Is that it? The bid is 15.50 for RGR by the way.

Share your thoughts...

We encourage people to join in on the discussion. Please keep in mind however, that all comments are moderated according to our comment policy, and all links are nofollow. Let's keep the conversation professional and meaningful.