Algorithmic and Mechanical Forex Strategies | OneStepRemoved

SPY Crisis Strategy Questions

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Ed wrote me an email asking how he can trade the SPY Crisis Strategy. He likes the idea, but the problem is that his account balance is too small. He was under the impression that he can only participate with a futures account.

That was true several years ago. Luckily, the brokers have wised up and offer traders many more options. SPY is the ETF based on the S&P 500. ETFs are technically “Exchange Traded Funds”, but you can think of the SPY as a stock. You would place SPY trades in the same way that you buy or sell any stock in your brokerage account. Wikipedia offers a great ETF explanation if you’re new to the concept.

The returns that I posted for the strategy assumed that you were trading SPY without leveraged. If you’re a forex or futures trader, there are a few options available:

Forex traders can inquire if their broker offers index CFDs, especially if you want to trade the idea from MetaTrader. A CFD stands for “Contract For Delivery”, but don’t worry. Your broker has no desire or interest to make deliveries on oil or the S&P 500 CFDs. CFD is a legalistic creation where the broker promises to deliver the object traded on a certain date. In reality, the contract is perpetually rolled 2 days into the future. The position allows you to hold the spot price of the S&P 500 without needing to purchasing any stocks or resorting to the futures market.

The best option for futures traders are the e-minis (Symbol: ES). You should trade the front month contract for all signals. This is certainly the most efficient way to trade the idea. The only reason I stuck with the ETF is that I don’t have to dive into messy backtesting assumptions with continuous contracts and rolling open positions.

NinjaTrader is a great option regardless of the instrument that you trade. It’ll handle any market that you select: CFD, futures or the ETF.

Developing a System Around an RSI Entry Strategy

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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.

Current Examples

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.

RSI Entry on TTWO

TTWO shows a good chance of correcting upward over the next few days

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.

RSI Entry WBS

The RSI entry rules show that WBS is due for a correction in the short term.

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.