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Relative Strength Index (RSI) Systems

The most direct Relative Strength Index trading system is to buy when the RSI oscillator moves into its oversold range and sell when it enters the overbought range. This forms a basic countertrend or contrarian trading system, and employs the appealing logic of "buy low, sell high." Here are the results of this system on the same stocks and time period as the systems above.

System 7: Buy if RSI crosses below 30, Sell if RSI crosses above 70 

Avg profit per trade (% gross)            2.5
Avg days held                            40.1
Profitable trades (%)*                   61.3

Avg drawdown (%)                         12.4
Max drawdown (%)                         93.0
Avg profit/avg drawdown                   0.2
Notably, this system is the most profitable of any of the simple systems described so far. The average profit per trade is 2.5 (gross), and its profitable 61% of the time after accounting for reasonable transaction costs. While potentially profitable, it is unmanageably risky. The average drawdown is over 12%, which is too much to risk to tolerate given the potential gain. As a rule of thumb, a trading system should have an average profit to average drawdown ratio of at least 1:1 to be viable, though clearly the higher the better.

Stop-losses can put a bound the amount of downside risk. The next system applies a stop-loss to the prior system.

System 8: Buy if RSI crosses below 30, Sell if RSI crosses above 70, Stop-loss = 10%. 

Avg profit per trade (% gross)            0.7
Avg days held                            22.7
Profitable trades (%)*                   52.1

Avg drawdown (%)                          3.6
Max drawdown (%)                         44.5
Avg profit/avg drawdown                   0.2
In this example, the stop-loss completely eliminates the profit of the original system and turns it into a system that loses money overall. With the stop-loss, only about 20% of the trades are profitable overall. A more liberal stop loss, say 20%, also destroys the profitability of the system.

A potential improvement that is sometimes suggested is to buy when RSI emerges from the oversold level, and sell when it falls below the overbought level. The intuition is to wait to act until sell-offs and rallies have played out.

System 9: Buy when RSI crosses above 30, Sell when RSI crosses below 70. 

Avg profit per trade (% gross)            1.8
Avg days held                            39.8
Profitable trades (%)*                   59.4

Avg drawdown (%)                         12.9
Max drawdown (%)                         93.1
Avg profit/avg drawdown                   0.1
These results differ little from the original RSI trading system, and if anything produce inferior results. The profit per trade is diminished, but the average drawdown is about the same.

Continue to part 8 - "Systems using the `traditional' and `statistical' technical scores"


Contents: A View on Technical Indicators and Trading Systems