TRADING THE ODDS

A few days ago Michael Stokes at MarketSci made an excellent post concerning RSI(2) readings, the changing frequency of extreme readings, its (the RSI’s) quality of forecast and efficiency of trading short-term mean-reversion in the markets over the course of time since 1950 (Extreme RSI(2) Readings Becoming Less Common, and he already covered the topic here and here), and based on his findings and conclusions -for exemplary purposes- I set up a static trading strategy (static means no adjustments of RSI time frame and break points) for the time frame since 1993 (SPY, see Trading the RSI as a Static Strategy) which would not only have been profitable over the course of time but would have been outperformed the index as well (and on top of that with a lesser maximum month-end drawdown).

But what would Michael’s finding that extreme RSI(2) readings currently become less common than in the past mean percentage-wise concerning a potential RSI(2) strategy ?

I conducted the same analysis for the time frames from 1950 until 1970, 1970 until 1990 and 1990 until 2009 for the S&P 500 with a 2-day RSI as I did for the static trading strategy with an RSI (2.5) for the SPY, meaning I determined the distribution of gains and losses on those sessions (the first and second day thereafter) immediately following a session when the S&P 500 RSI(2) closed between a lower and upper break point in order to evaluate an ideal exit point for a potential RSI(2) strategy (where the sum of all gains minus the sum of all profits = expectancy turns from positive to negative, which means -on average- the maximum possible gain on the upside would have been achieved).

For the three different time frames from 1950 to 1970, 1970 to 1990 and 1990 to 2009 , the following tables Table I to Table III show the respective distribution of profits and losses for the S&P 500 and the RSI(2) over the course of the then following 2 sessions, broken down by different ranges (potential upper breaking points) for the RSI (2), assumed one would’ve bought the S&P 500 on close of every session when the RSI (2) closed anywhere between the lower and the upper break point (no overlapping trades allowed). Please take a special look at the third last row (‘Profitability’).

Table I (1950 – 1970)

Regarding the time frame from 1950 until 1970

• all RSI(2) readings above 70 led -over the course of the then following two sessions- on total to profitable trades if one would have bought the S&P 500 on close of a session with an RSI(2) reading between the lower and upper break point,
• all RSI(2) readings above 70 show positive win/loss ratio, profitability and profit factor significantly above the at-any-time profit factor for the time frame from 1950 until 1970, and
• there were significantly more extreme RSI(2) readings between 90 and 100 than between 70 and 90 combined (the sum off all occurrences between 70 and 90),
• and RSI(2) readings between 90 and 100 show the highest profitability of all RSI(2) ranges.

So any RSI(2) strategy build upon a potential short on any RSI(2) reading above 90 would have been a clear receipt for disaster, and the upper break point would had to been set close to 100 in order to achieve maximum gains on the upside.

____________________________________

Table II (1970 – 1990)

Regarding the time frame from 1970 until 1990

• all RSI(2) readings above 70 led -over the course of the then following two sessions- on total to profitable trades if one would have bought the S&P 500 on close of a session with an RSI(2) reading between the lower and upper break point,
• all RSI(2) readings above 70 show positive win/loss ratio, profitability and a profit factor either slightly, partly significantly above the at-any-time profit factor for the time frame from 1970 until 1990, and
• the amount of extreme RSI(2) readings between 90 and 100 approximately equals the total amount of RSI(2) readings between 70 and 90 combined (the sum off all occurrences between 70 and 90),
• and RSI(2) readings between 80 and 90 show the highest profitability of all RSI(2) ranges.

So any RSI(2) strategy build upon a potential short on any RSI(2) reading above 90 would have been still a clear receipt for disaster, and the upper break point would had to been set close to 90 in order to achieve maximum gains on the upside.

But profitability and total amount of extreme RSI(2) were less extreme than the respective figures concerning the time frame from 1950 until 1970.

____________________________________

Table III (1990 – 2009)

Regarding the time frame from 1990 until 2009

• only RSI(2) readings between 75 and 80 led -over the course of the then following two sessions- on total to profitable trades if one would have bought the S&P 500 on close of a session with an RSI(2) reading between the lower and upper break point,
• only RSI(2) readings below 80 show positive win/loss ratios and a profit factor close to the at-any-time profit factor for the time frame from 1900 until 2009, and
• the amount of extreme RSI(2) readings between 90 and 100 approximately equals half of the total amount of RSI(2) readings between 70 and 90 combined (the sum off all occurrences between 70 and 90).

So any RSI(2) strategy build upon a potential short on any RSI(2) reading above 90 could have been profitable for the first time since 1950, and the upper break point would had to been set somewhere between 70 and 80 in order to achieve maximum gains on the upside

So I completely agree with Michaels bottom line (cit.) ‘… the markets are becoming more contrarian in the short-term. That means the market tends not to move in a single direction for as long, which means that the market tends to register less extreme readings on short-term indicators such as this one.‘

Successful trading,

Frank

P.s.: Wordpress recently implemented a Twitter widget, so I’ll regularly make some intraday updates as well using Twitter (as I already did during the last couple of session, but unfortunately there seems to be a connectivity issue between Wordpress and Twitter; hope that will be solved soon). If you’re interested in, please have a look at the blog during the trading session as well or subscribe directly to Twitter.

A few days ago Michael Stokes at MarketSci made an excellent post concerning RSI(2) readings, the changing frequency of extreme readings, its (the RSI’s) quality of forecast and efficiency of trading short-term mean-reversion in the markets over the course of time since 1950 (Extreme RSI(2) Readings Becoming Less Common, and he already covered the topic here and here).

Although I completely agree to his findings and conclusions which could be summarized as (cit.) ‘I don’t think this says anything about the effectiveness of strategies based on indicators such as RSI(2), but it does say that they might trigger a bit less over time.‘ and (cit.) ‘But I would be hesitant to trade the RSI(2) in the simple form I’ve described here as a static strategy.‘, I was incited by Bill Luby’s comments on Michael’s post concerning the usage of deviating break points (e.g. 95/5 and 98/2 instead of 90/10) and/or different moving averages (e.g. RSI (3) and RSI (4) instead of RSI (2)).

The RSI Relative Strenght Index was developed by J. Welles Wilder and introduced in 1978. The RSI (x days) oscillates between 0 and 100 and compares the magnitude of an assets (e.g. stock or index) recent gains to the magnitude of its recent losses, with low readings indicating oversold and high readings indicating overbought conditions.

My objective was to check if and to what extend the Relative Strength Index (not taking into account any additional indicator and/or condition, so in its pure form) could be utilized for a mechanical (and static) trading strategy, with investigations focused on the following questions:

• could an RSI based strategy stand the test of time without any adjustments (e.g. break points) and/or adaptions to the then current market conditions (e.g. bull/bear markets),
• its profitability year by year, in the long run, and its capability to deliver positive returns in bull and bear markets likewise,
• its capability to outperform the SPY as a tradable proxy for the S&P 500,
• the possibility to reduce the time in market in comparison to a buy and hold approach (which is always in the market) in order to reduce the risk of being hit by a potential ‘black swan’ event.

As an additional restriction I took into account and allowed for long trades only (the addition of potential short sales will probably be addressed in a future post), and no adjustements  (e.g. break points) are allowed for. No leverage is taken (no position sizing, money management and/or stops except the break points), but the strategy is always ‘all in’ (compounded returns, means any potential profits are always reinvested on the next trade in order to be comparable to a ‘buy and hold’ approach which is evenly always ‘all in’, assumed that no money is taken out). Due to the fact that this is a proof of concept/survey only, performance figures do not account for commissions, fees and slippage.

First of all I figured out that with respect to all the conditions listed above, it is not the 2-day or 3-day or 4-day RSI but the 2.5-day RSI which met those requirements best. Sounds surprisingly, but with respect to the computation of the RSI is makes no difference using 2.5 as a moving average instead of 2/3/4/… /x (even numbers for the number of sessions).

The next step was to evaluate the ideal lower and upper break points. From my perspective the optimal approach would be to determine the distribution of gains and losses (for the SPY) over the course of the then following first two days after a trade would have been entered at the lower break point, broken down by different RSI (2.5) ranges, and respectively at the upper break point in order to ride any upmove to its ideal extent (and before any potential profit would turn into a loss). For the time frame since 01/03/1993, the following tables (Table I for the upper break point,and Table II for the lower break point) show the respective distribution of profits and losses for the SPY over the course of the then following 2 session, broken down by different ranges for the SPY’ RSI (2.5), assumed one would’ve bought the SPY on close of every session when the RSI (2.5) closed anywhere between the lower and the upper break point (no overlapping trades allowed).

In order to maximize profits, the ideal exit is located between 67.5 and 72.5. That would present the ideal upper break point because any exit above (too late) or below (too early) would have reduced any already achieved or have missed any potential further gains due to the fact that the market’s tendency to reverse course significantly increased with an RSI (2.5) above 70. The same principle applies to the lower break point. The highest profitability (sum of all gains minus the sum of all losses, not the profit factor or anything else because the ‘opportunity factor’ plays a decisive role) would have been achieved with a lower break point of 18 (+179.06% during the then following two days if one woud have bought the SPY on close of every day when the RSI (2.5) closed below 18).

Strategy: Buy the SPX on close of a session when the RSI (2.5) closes below the lower break point (18); close the trade on close of a session when the RSI (2.5) closes above the upper break point (70).

(please note that trade performance figures were assigned to the date -and therefore regarded as achieved and realized- when the ‘buy’ was triggered, not on the date the trade was closed; that doesn’t make a difference concerning the total gains/lossed achieved, but due to the deviating distribution of gains/losses -not their total- the equity curve would look a bit different)

Table I

Table II

Table III shows the respective equity curve. Some additional stats:

• Maximum month-end drawdown: -11.22%
• % month positive: 74%
• Month outperformance SPY: 52.85%
• Time in market: 31.50%

So I completely agree with Michaels bottom line (cit.) ‘I do think RSI(2) has wings in today’s market. … But I would be hesitant to trade the RSI(2) in the simple form I’ve described here as a static strategy.‘, but not mainly concerning the point that it wouldn’t make sense to trade the RSI (2.5) as a static strategy (which would have been considerably profitable, less risky than a ‘buy and hold’ approach and would have almost always outperformed the SPY, but with hindsight only because we determined the ideal break points in 2009 and not in 1993) but in particular with respect to the fact that it will probably be possible to build a strategy around the RSI (2.5) in combination with one or more other indicator/conditions like Michael does in his State of the Market report which would be superior to any static RSI strategy alone.

Successful trading,

Frank

P.s.: Wordpress recently implemented a Twitter widget, so I’ll regularly make some intraday updates as well using Twitter (as I already did during the last couple of session, but unfortunately there seems to be a connectivity issue between Wordpress and Twitter; hope that will be solved soon). If you’re interested in, please have a look at the blog during the trading session as well or subscribe directly to Twitter.