While Jim Cramer likes to take fundamentals into consideration when investing in stocks, there is also added value to using the charts to make a decision. That is why he decided to focus on the technicals of a stock, especially when it comes to determining if a stock is overbought and ripe for a pullback — or oversold and ready for a bounce.
Investors can determine if a stock is overbought or oversold by charting the ratio of higher closes, also known as the relative strength index, or RSI. This is a momentum oscillator that measures the direction that a stock is going, and the velocity of the move.
Cramer also likes to match the RSI of an individual stock to something else, maybe the relative strength of its sector or a larger index, and then measure the price action historically. He looks for anomalies where strength stands out, because that is a sign that there is a pending move or a change in momentum.
"Typically, when a stock gets overbought it is ripe for a pullback because overbought stocks, ones with many buyers reaching to take in supply, tend to snap back after they have gotten too far away from their longer term trend line," the "Mad Money" host said.
The inverse can also be true. This means a stock can also fall so fast that investors should expect it to snap back, because it is technically oversold. These patterns are reliable indicators that a change in direction is about to occur, and are terrific action points.
So, if you are debating whether to buy a stock, have done all the research and find that the stock is overbought, Cramer said to wait for the inevitable pullback that almost always happens.