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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
Conclusions
So which one is better? The accumulated strategy worked as intended. It increased the efficiency of the standard RSI(2) trading system by reducing the number of trades, yet produced about the same amount of net profit. As a bonus, the drawdown was even slightly smaller. While both systems do a fantastic job, the accumulation strategy may do a slightly better job. The Accumulated RSI(2) strategy will work well on the mini Dow as well as the two ETFs, DIA and SPY.
S&P CASH MARKET
As a quick test on a market with more historical data, lets try it on the S&P cash market. Below are the results trading 100 shares going back to 1993. No commissions or slippage were deducted. It does rather well.
Download
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.
Hi
I've looked at a few discussions on this over the last few weeks and they all seem to do a blind buy if the rsi < 5. What about only buy if a new high is formed or a close above the previous bars high?
Perhaps this test is done in the code but nobody mentions this.
”Short Term Trading Strategies That Work” by Larry Connors and Ceasar Alvarez. I did try them on YM and NQ and while profitable, its not nearly as effective.
I have testing such things as buying on a the highest high over the past two bars, but with not much luck. I don't have the results handy. However, these are good ideas and worthy of testing.
Of course, the code is freely available so I encourage people to download it and play with it. This is not a trading system, but a concept which is freely available to experiment with.
I looked at 2-period DoubleStochastic a while ago on YM/NQ. It's a workable strategy if you add a dash of context into the mix (should not be blindly taking signal without contextual consideration) and manage the trade well (go for small losses and bigger winners).
You are never in the wrong place... but sometimes you are in the right place looking at things in the wrong way.