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What is RSI and how do we use it?

Relative Strength Index (RSI) is a popular technical indicator used in the stock market to measure the strength of a stock's price action. It is a momentum indicator that compares the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset.

The RSI is calculated using a simple mathematical formula that compares the average gains to the average losses over a specified period of time. The default period is typically 14 days, but it can be adjusted to suit the trader's preference. The RSI value ranges from 0 to 100, with values above 70 indicating an overbought market and values below 30 indicating an oversold market.

Traders can use RSI to identify potential turning points in a stock's price action. When the RSI is above 70, it indicates that the stock may be overbought and may be due for a correction. Conversely, when the RSI is below 30, it indicates that the stock may be oversold and may be due for a rebound. Lining up an RSI below 30 with a level of support is a very bullish entry we like to target, while lining up an RSI above 70 with a level of resistance is a great bearish entry.

It is also important to note that RSI can also be used to identify trend strength. A stock with an RSI above 50 is considered to be in an uptrend, while a stock with an RSI below 50 is considered to be in a downtrend.

While we're not hugely into TA, RSI is one that we have seen work time and time again. And the great part about option selling is that even if we don't nail the top or bottom perfectly, the cushion option selling offers us allows us time to sit back and let RSI go to work.

Here are a few great real-life examples we've recently had:

1) PDD

To speak to how effective RSI has been, we've circled the last 3 instances of it breaking above 70, indicating the stock was overbought. In each of those three instances, the stock dipped almost immediately afterwards. This past week was no different as we were able to bag some profit from the pullback.

2) TJX

Another almost identical example. 3 instances of RSI exceeding 70, 3 instances of the stock price cooling off or trading flat for a period of time afterwards. We sold 83c on this stock and bagged another nice profit.

One other great thing about these two examples... The recent pullbacks both occurred while the market was rallying. So even if the market continues upwards a lot of the times these stocks get exhausted after such a steep run-up and you can still make profit off a bearish trade.

How did we find these two? The answer is through our option scanners, which are available to download for your own use through ThinkorSwim as a part of our HT Premium package.

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