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Source : http://www.tradingmarkets.com/.site/stocks/commentary/editorial/2-Period-RSI.cfm
Most traders use the 14-period RSI, but our studies have
shown that statistically, there is no edge going out that far. However, when
you shorten the timeframe you start seeing some very impressive results. Our
research shows that the most robust and consistent results are obtained by using
a 2-period RSI and we have built many successful trading systems
that
incorporate the 2-period RSI.
Before getting to the actual strategy,
here’s a little background on the RSI and how it’s calculated.
Relative Strength Index
The Relative Strength Index (RSI) was developed by J. Welles
Wilder in the 1970's. It is a very useful and popular momentum oscillator that
compares the magnitude of a stock's recent gains to the magnitude of its recent
losses.
A simple formula (see below) converts the price action into a
number between 1 and 100. The most common use of this indicator is to gauge
overbought and oversold conditions - put simply, the higher the number the more
overbought the stock is, and the lower the number the more oversold the stock
is.
RS = Average of x days up closes / Average of x
days down closes
As mentioned above, the default/most common
setting for RSI is 14-periods. You can change this default setting in most
charting packages very easily but if you are unsure how to do this please
contact your software vendor.
2-Period RSI
We looked at over seven million trades from 1/1/95 to
6/30/06*. The table below shows the average percentage gain/loss for all stocks
during our test period over a 1-day, 2-day, and 1-week (5-days) period. These
numbers represent the benchmark which we use for comparisons.
We then quantified overbought and oversold conditions as
measured by the 2-period RSI reading being above 90 (overbought) and below 10
(oversold). In other words we looked at all stocks with a 2-period RSI reading
above 90, 95, 98 and 99, which we consider overbought; and all stocks with a
2-period RSI reading below 10, 5, 2 and 1, which we consider oversold. We then
compared these results to the benchmarks, here's what we found:
Oversold
When looking at these results, it is important to understand
that
the performance improved dramatically each step of the way. The average returns
of stocks with a 2-period RSI reading below 2 were much greater than those
stocks with a 2-period RSI reading below 5, etc.
This means traders should look to build
strategies around stocks with a 2-period RSI reading below 10.
Overbought
When looking at these results, it is important to understand
that
the performance deteriorated dramatically each step of the way. The average
returns of stocks with a 2-period RSI reading above 98 were significantly lower than
those stocks with a 2-period RSI reading above 95, etc.
This means stocks with a 2-period RSI
reading above 90 should be avoided. Aggressive traders may look to build short
selling strategies around these stocks.
As you can see, on average, stocks with a 2-period RSI below 2
show a positive return over the next week (+0.87%). Also shown is that, on
average, stocks with a 2-period RSI above 98 show a negative return over the
next week. And, just as the other articles in this series have shown (view
archives), these
results can be improved even further by filtering stocks trading above/below the
200-day moving average and combining the 2-period RSI
with
PowerRatings.
Recent Examples
Chart 1 (below) is an example of a stock that
recently had a 2-period RSI reading below 2:
Chart 1
Chart 2 (below) is an example of a stock that
recently had a 2-period RSI reading above 98:
Chart 2
Our research shows that the Relative Strength Index is indeed an
excellent indicator, when used correctly. We say "when used correctly"
because our research shows that it is possible to catch short-term moves
in stocks using the 2-period RSI, but it also shows that when using the "traditional"
14-period RSI there is little/no value to this indicator. This statement cuts to
the very essence of what TradingMarkets represents - we base our trading
decisions on quantitative research. This philosophy allows us to objectively
assess whether a trade offers a good risk/reward opportunity and what might
happen in the future.
This research we're presenting here is just the tip of the
iceberg using the 2-period RSI. For example, greater results can be found by looking for
multiple day readings under 10, 5 or 2. And, even greater results can be achieved by
combining the readings with other factors such as buying a low level RSI stock
if it trades 1-3% lower intraday.
Most traders use the 14-period RSI, but our studies have
shown that statistically, there is no edge going out that far. However, when
you shorten the timeframe you start seeing some very impressive results. Our
research shows that the most robust and consistent results are obtained by using
a 2-period RSI and we have built many successful trading systems
that incorporate the 2-period RSI.
Before getting to the actual strategy,
here’s a little background on the RSI and how it’s calculated.
Relative Strength Index
The Relative Strength Index (RSI) was developed by J. Welles
Wilder in the 1970's. It is a very useful and popular momentum oscillator that
compares the magnitude of a stock's recent gains to the magnitude of its recent
losses.
A simple formula (see below) converts the price action into a
number between 1 and 100. The most common use of this indicator is to gauge
overbought and oversold
conditions - put simply, the higher the number the more overbought the stock is, and the lower the number the more oversold the stock
is.
RS = Average of x days up closes / Average of x
days down closes
As mentioned above, the default/most common
setting for RSI is 14-periods. You can change this default setting in most
charting packages very easily but if you are unsure how to do this please
contact your software vendor.
2-Period RSI
We looked at over seven million trades from 1/1/95 to
6/30/06*. The table below shows the average percentage gain/loss for all stocks
during our test period over a 1-day, 2-day, and 1-week (5-days) period. These
numbers represent the benchmark which we use for comparisons.
We then quantified overbought and oversold conditions as
measured by the 2-period RSI reading being above 90 (overbought) and below 10
(oversold). In other words we looked at all stocks with a 2-period RSI reading
above 90, 95, 98 and 99, which we consider overbought; and all stocks with a
2-period RSI reading below 10, 5, 2 and 1, which we consider oversold. We then
compared these results to the benchmarks, here's what we found:
Oversold
- The average returns of stocks with a 2-period RSI reading
below 10 outperformed the benchmark
1-day (+0.06%), 2-days (+0.21%), and 1-week later (+0.50%).
- The average returns of stocks with a 2-period RSI reading
below 5 significantly outperformed the benchmark
1-day (+0.12%), 2-days (+0.33%), and 1-week
later (+0.65%).
- The average returns of stocks with a 2-period RSI reading
below 2 significantly outperformed the benchmark
1-day (+0.22%), 2-days (+0.51%), and 1-week
later (+0.87%).
- The average returns of stocks
with a 2-period RSI reading below 1 significantly outperformed the benchmark
1-day (+0.27), 2-days (+0.62%), and 1-week later
(+1.05%).
When looking at these results, it is important to understand
that
the performance improved dramatically each step of the way. The average returns
of stocks with a 2-period RSI reading below 2 were much greater than those
stocks with a 2-period RSI reading below 5, etc.
This means traders should look to build
strategies around stocks with a 2-period RSI reading below 10.
Overbought
The average returns of stocks with a 2-period RSI reading
above 90 underperformed the benchmark
2-days, and 1-week later.
The average returns of stocks with a 2-period RSI reading
above 95 underperformed the benchmark
2-days later, and were negative 1-week later (-0.03%).
The average returns of stocks with a 2-period RSI reading
above 98 were negative 1-day (-0.02%),
2-days (-0.13%), and 1-week later (-0.18%).
The average returns of stocks with a 2-period RSI reading
above 99 were negative 1-day (-0.08%),
2-days (-0.24%), and 1-week later (-0.31%).
When looking at these results, it is important to understand
that
the performance deteriorated dramatically each step of the way. The average
returns of stocks with a 2-period RSI reading above 98 were significantly lower than
those stocks with a 2-period RSI reading above 95, etc.
This means stocks with a 2-period RSI
reading above 90 should be avoided. Aggressive traders may look to build short
selling strategies around these stocks.
As you can see, on average, stocks with a 2-period RSI below 2
show a positive return over the next week (+0.87%). Also shown is that, on
average, stocks with a 2-period RSI above 98 show a negative return over the
next week. And, just as the other articles in this series have shown (view
archives), these
results can be improved even further by filtering stocks trading above/below the
200-day moving average and combining the 2-period RSI
with
PowerRatings.
Recent Examples
Chart 1 (below) is an example of a stock that
recently had a 2-period RSI reading below 2:
Chart 1
Chart 2 (below) is an example of a stock that
recently had a 2-period RSI reading above 98:
Chart 2
Our research shows that the Relative Strength Index is indeed an
excellent indicator, when used correctly. We say "when used correctly"
because our research shows that it is possible to catch short-term moves
in stocks using the 2-period RSI, but it also shows that when using the "traditional"
14-period RSI there is little/no value to this indicator. This statement cuts to
the very essence of what TradingMarkets represents - we base our trading
decisions on quantitative research. This philosophy allows us to objectively
assess whether a trade offers a good risk/reward opportunity and what might
happen in the future.
This research we're presenting here is just the tip of the
iceberg using the 2-period RSI. For example, greater results can be found by looking for
multiple day readings under 10, 5 or 2. And, even greater results can be achieved by
combining the readings with other factors such as buying a low level RSI stock
if it trades 1-3% lower intraday.
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