Monday, October 29, 2007

New Research On RSI(2): A Profitable Indicator?

As many traders know, many indicators are often representations of similar measures. I prefer to not get bogged down with multiple measures of a trend. To keep things simple, I typically monitor price and volume, MACD, RSI, and sometimes the Stochastics. While the MACD can help traders judge the strength of a trend and also identify when a new trend is beginning, the RSI is often used to help with timing, i.e., when to get in, and when to get out of a trade.

Because of its simplicity, the Relative Strength Index (RSI) is one indicator that has always made intuitive sense to me. The calculation is simply the average of x days up closes / x days down closes. What traders have often differed on is what average to use. The default with most charting software is 14 days. However, several bloggers have advocated, or at least discussed using a 2 day average. I know Bill Rempel, Bullish Jim, and Marlyn from Filtering Wall Street (no longer being updated) have all presented trades using the 2 day RSI.

Finally I have come upon some research which shows the benefit of using a 2 day RSI average. In the November issue of Technical Analysis of Stocks and Commodities, an article by Larry Connors and Ashton Dorkins describes the results of testing more than eight million trades from January 1, 1995, to December 31, 2006. The average one week percentage gain or loss for all stocks during the period tested was +0.25%.

After quantifying overbought and oversold conditions (RSI above 98 is overbought; RSI below 2 is oversold), their research showed that stocks with a 2 period RSI below 2 averaged a gain of +0.88% one week later (beating the benchmark average by more than 3:1). Conversely, stocks that were overbought with a 2 day RSI greater than 98 lost money (-0.17%) one week later as well as underperforming the benchmark.

The implications of this research are crystal clear: Traders should use a 2 period RSI if they want the indicator to actually give them an edge.

After reading this article, I set out to find a stock with a 2 day RSI below 2. I could have just programmed Stockfetcher (I think) to find some. However, that would have been too easy. I instead decided to pull up some stocks that have recently taken a beating. After the plunge VDSI experienced, I was certain it would make a good RSI<2 candidate. No luck there, as the RSI(2) was at 9.5.

Then I remembered WCG. Bingo! The RSI(2) is at 1.14.

The chart, which shows WCG losing 70% of its value in three trading days, shows why the RSI(2) works so well. When a stock is trading at extremely oversold levels, the most likely direction for it to go is up. While WCG would definitely be a buy if one was trading using the RSI(2), the fact that the stock is under a government investigation for alleged Medicare and Medicaid fraud right before the start of the enrollment period may mean that the normal bouncing process may not follow through in this particular name.

I intend to incorporate the RSI(2) in all future technical analysis.

2006. Connors, L. and Ashton Dorkins. "Does the RSI give you an edge?" Technical Analysis of Stocks and Commodities. 48-52, November, 2007.

10 comments:

Anonymous said...

You have no idea what you're talking about do you?

Woodshedder said...

Chuckle.

Why so cryptic?

Did I use too many two syllable words?

Dogwood said...

Write at the 6th grade level, easier for the haters to comprehend.

Andy said...

CATS (RSI2) 0.54
NLC (RSI2) 0.91

Woodshedder said...

Andy, CATS looks great. NLC looks okay, just not as orderly of a chart.

Too bad I'll miss most of today's action!

Andy said...

Neither of them fit my personal criteria - I was just throwing them out as RSI(2) candidates that aren't necessarily tainted by the WCG problem - although I do agree that CATS looks the better of the two

Anonymous said...

This is the one,it will beat plain RSI(2)any day of the week.
You need to wait for the stock to go positive intraday after hitting the filter before entering.

rsi(2)is below 5
weekly rsi(2)is below 10
average volume(90)is above 300000
price is above 10
average day range(30)is above 4
offset is 0

Give it a fair look if interested in making some bank.

Woodshedder said...

Anonymous, do you have the stockfetcher code for that?

Anonymous said...

Hi,that is it,just type it into SF.

btw,if you search SF forums for RSI(2) you will find tons of posts about it from over the last 4 and a half years.
That's when I started using it and know just about all angles to it that there are to know.

Anonymous said...

Larry Connors has done extensive work on the RSI2. Your info sounds a lot like his, plagiarism is still illegal right?