In chapter nine of their book Short Term Trading Strategies That Work, Larry Connors and Cesar Alvarez refer to Relative Strength Index (RSI) as “The Holy Grail of Indicators.” While I don’t like the implication that there is a “Holy Grail” in trading other than hard work and studying, Connors and Alvarez to provide some interesting research to back up their claim.
Connors and Alvarez Research
The standard period that is commonly used for the RSI indicator is 14, but Connors and Alvarez argue that there is no statistical evidence that 14 is the optimal period. Their testing has revealed that a period of 2 will provide the best returns.
Connors and Alvarez set out to test their theory over the time period from January 1, 1995 through December 31, 2007. During this time, they calculated that the average stock that was above its 200 day simple moving average (SMA) gained 0.05% over a 1-day period, 0.1% over a 2-day period, and 0.25% over a 3 day period. They used these numbers as a benchmark for their 2-period RSI indicator to compete against.
Focusing on the oversold side, stocks that had an RSI below 10 were able to outperform each of the three benchmarks. They recorded returns of 0.13% over a 1-day period, 0.31% over a 2-day period, and 0.74% over a 1-week period.
Not surprisingly, when they lowered the oversold requirement to an RSI below 5, the performance numbers improved even more. The numbers then improved again when they lowered the RSI requirement to 2, and once again when they lowered the RSI requirement to 1.
When the RSI requirement was lowered all the way down to one, the RSI indicator recorded returns of 0.3% for a 1-day period, 0.66% for a 2-day period, and 1.18% for a 1-week period. This indicates that the lower the RSI, the more the stock was likely to rebound. Clearly, the 2 period RSI indicator can perform extremely well on short term trades.
My Initial Resistance To Oversold Indicators
My early stock market training was a combination of William O’Neil’s CANSLIM method and the trend following approach promoted by Michael Covel. Because of that, I have always been against the concept of an overbought or oversold indicator. Following with my trend following and CANSLIM training, I believe that the stocks with the strongest relative strength are most likely to continue moving higher.
What I was missing, was the idea that short term overbought and oversold conditions can exist within long term trends. That means that overbought/oversold indicators and trend following philosophies do not necessarily have to be mutually exclusive.
One interesting example of using RSI to identify short-term oversold opportunities would be Take Two Interactive Software (TTWO), which took a big hit in today’s trading. My CANSLIM and Trend Following background tells me to avoid stocks that are taking big hits and crashing below their 50-day moving average on big volume, but that is a longer-term outlook. It would not be unreasonable for TTWO to bounce back over the next few days and then head further south.
The same case can be made for Webster Financial Corp (WBS) , which has recently lost its 50-day line and has been trending down for the past few weeks. While taking a long term position in this stock might not make much sense to a mid- or long-term trend follower, the stock’s 2-period RSI of 4.23 indicates that it is likely to see a small bounce over the next few days.
Systematizing This Concept
It is important to keep in mind that the profitable returns that Connors and Alvarez were able to produce in their returns came from including EVERY instance of a stock falling into oversold territory. They were not picking and choosing their favorite companies.
Therefore, in order for us to use this idea, we will have to build it into a system that will be able to trade every signal generated, not just the ones we like best. This will ensure that we don’t allow our own personal biases to interfere with the system’s success.
It is also important to realize that this 2-period RSI concept is simply an entry signal. In order to develop it into a trading system, we will need to add an exit signals, position sizing, and risk management. This will require extensive testing and analysis, but it does appear that it would be possible to build a profitable short-term trading system using the 2-period RSI as an entry signal.