RSI And How To Profit From It

We all know there are no magic indicators but there is an indicator that certainly acted like magic over the past 10 years or so. What indicator is it? Our reliable RSI. In this article we are going to look at two trading systems that were first talked about in the book, ”Short Term Trading Strategies That Work” by Larry Connors and Ceasar Alvarez. It has been well established in various articles on the web that a 2-peirod RSI on the daily chart of the stock index markets has been a fantastic tool for finding entry points. Sharp price drops in the S&P E-Mini futures during bullish markets have historically (since the year 2000) been followed by reversals. These reversals can often be detected by using the standard RSI indicator with a period value of two. Place this indicator on a daily chart and look for points when the indicator falls below five, for example. These extreme low points are buying opportunities.

RSI(2) SYSTEM

We can turn this into a simple strategy to test the effectiveness of the RSI(2) indicator on the E-mini S&P. In short, we wish to go long on the S&P when it experiences a pullback in a bull market. We can use a 200-day simple moving average to determine when we are in a bull trend and using a 2-period RSI to locate high probability entry points. We can then exit when price closes above a 5-day simple moving average. The rules are clear and simple:

• Price must be above its 200-day moving average.
• Buy on close when cumulative RSI(2) is below 5.
• Exit when price closes above the 5-day moving average.
• Use a $1000 catastrophic stop loss.

The system backtest was performed from September 1997 through March 2012. A total of $50 for commissions and slippage was deducted per round trip. Below is a chart of what this system would look like along with the system results.

RSI(2) SYSTEM RESULTS

Net Profit: $17,163

Percent Winners: 67%

No. Trades: 64

Ave Trade: $268.16

Max Drawdown: -$5,075

Profit Factor: 1.90

These results are great considering we have such a simple system. This demonstrates the power the RSI(2) indicator has had now for well over a decade. Just with this concept alone you can develop several trading systems. For now, let’s see if we can we improve upon these results.

ACCUMULATED RSI(2) STRATEGY

Larry Conners adds a slight twist to the RSI(2) trading system by creating an accumulated RSI value. Instead of a single calculation we will be computing a running daily total of the 2-period RSI. In this case, we are going to use the total of the 2-period RSI for the past three days. When you keep an accumulated value of the RSI(2) you smooth out the values. Below is a chart comparing the standard 2-period RSI indicator with an accumulated 2-period RSI indicator. You can see how much smoother our new indicator is. This is done to reduce the number of trades in hopes of capturing the quality trades. In short, it’s an attempt to improve the efficiency of our original trading system.

The rules are:

• Price must be above its 200-day moving average.
• Buy on close when cumulative RSI(2) of the past three days is below 45.
• Exit when RSI(2) of the close of current day is above 65.
• Use a $1000 catastrophic stop loss.

ACCUMULATED RSI(2) SYSTEM RESULTS

Net Profit: $17,412

Percent Winners: 67%

No. Trades: 52

Ave Trade: $334.86

Max Drawdown: -$4,850

Profit Factor: 2.02

The EasyLanguage code is available below as a free download. There is also a tradestation workspace. Please note, the trading concept and the code as provided is not a complete trading system. It is simply a demonstration of a robust entry method that can be used as a core of a trading system. So, for those of you who are interested in building your own trading systems this concept may be a great starting point.

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