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 I know Bill Rempel, Bullish Jim, and Marlyn from Filtering Wall Street (no longer being updated) have all presented trades using the 2 day RSI.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.

New Research from Journal of Financial Planning

Improved Study Finds Index Management Usually Outperforms Active Management

by Millicent Holmes

Executive Summary

This study seeks to improve in several ways upon previous studies examining the relative performance of index management versus active management. It concludes that index management outperforms active management in most asset classes.

• To make comparisons between index management and active management as accurate as possible, the study segregated funds by style and then compared funds of the same style. This "apples to apples" comparison is the most accurate methodology. Many other studies suffer from some level of benchmark mis-specification or "size bias," as they compare all actively managed funds, which include Large-, Mid-, Small-, and Micro-cap funds to a Large-Cap Blend index, the S&P 500.
  
• Many studies on indexing versus active management have used only gross returns, which tend to overstate active manager fund performance. By contrast, this study examines fund performance net of management fees, expenses, and the impact of taxes.
  
• Also, these studies typically have used commercial mutual fund databases as their investment universe. Unfortunately, all commercial databases suffer from survivor bias, overstating the returns for the universe of active managers that have survived to the present date. This study uses "survivor-biased minimized" data to help solve this difficulty.
  
• In general, index management outperformed active management in the Large-Cap Blend, Value, and Growth asset classes. The results in Mid-Cap were mixed, with active Mid-Cap Value outperforming index management for most periods. Active management also outperformed in active Small-Cap Blend and international Mid/Small-Cap Blend.
  
• Surprisingly, indexing outperformed active management in the active Small-Cap Value and Growth asset classes, precisely the asset classes in which one would expect active management to outperform index management.

Millicent Holmes is director of research at Brownson, Rehmus & Foxworth Inc., a firm in Chicago, Illinois, that offers comprehensive wealth management, including investment consulting and multi-family office services. Her past experience includes working with fund of hedge fund managers, developing alternative investment products for international institutional investors in the United States and abroad, and trading options from the floors of the Chicago Board of Trade and Chicago Mercantile Exchange.