There are very many ineffective strategies that cannot bring steady profits in the stock market. Confusion arises from the massive number of indicators, and even long-term professionals suffer huge losses without a good strategy.
It has been widely used as a reliable tool for most traders, especially those who are focused on mean-reversion strategies. Its simplicity and effectiveness in identifying overbought and oversold conditions make it extremely effective as an indicator for swing traders and continues to be used in the large majority of trading applications.
In this article, we present three RSI strategies along with some rules for trading and backtesting. These concepts are based on mean reversion; under which the trader can better make their decisions through the signals that RSI issues. Making yourself familiar and applying the following strategy will highly profit your trading.
Strategy 1: Two-Day RSI Strategy
Trading Rules
- Buy Signal : Issue a long position if the two-day RSI crosses below 10.
- Sell Signal: Close the position when the two-day RSI crosses above 80.
The strategy is named the two-period RSI strategy, and has been backtested using the S&P 500 ETF (SPY). The trade is entered at the close of the day.
Backtest Results
In this strategy, starting with a capital of $100,000, it grows to approximately $1.2 million after 30 years. It is compounded annually by an average return of 8.5%. Note that market exposure only occurs 27% of the time-such a disciplined approach.
Performance Metrics
- Max Drawdown: The drawdown can be quite high for this strategy, keeping away some traders.
Strategy 2: Refinement of the Two-Day RSI Strategy
Trading Rules
- Buy Signal: Same as Strategy 1, buy when the two-day RSI crosses below 10 .
- Sell Signal: Exit the position when the close is higher than the highest price from the previous day (a strategy known as the Qs exit).
Backtest Results
Whereas this approach takes off from the same $100,000, it grows to $950,000 over the same time horizon. The overall return is smaller, but the trading experience is smoother with much less volatility.
Performance Metrics
- Max Drawdown: In this example, the max drawdown is limited to 23%, and normal draws down hardly ever exceed 12%. This is a more stable type of risk profile, which most investors like to see.
Comparison
The former has higher returns but much larger drawdowns. The latter provides a better risk-adjusted return to most traders, hence, more favored to most of the traders.
Strategy 3: RSI Momentum Strategy
Trading Rules
Indicators: A 14-day RSI with a lookback of 100 days to capture market regimes.
Long Position: Entry on the signals of regime bullishness.
- Exit Position: Exit if the market is not in a bullish regime.
Backtest Results
The RSI momentum strategy produces fewer signals, with only 12 trades over the backtesting period, of which only two are losing trades. But the performance lags a bit more than the first two mean reversion strategies.
Performance Metrics
This strategy offers a strong return but is not an active strategy, which makes it more suitable for traders who prefer less frequent trade approaches.
Analysis of RSI Strategies
Why These Rules?
These strategies consider the strength of RSI about the overbought and oversold conditions. A mean reversion approach is given so that the traders can take advantage of any corrections in price.
RSI Effectiveness
The RSI indicator works well with stock trading and stock ETFs. It shows that in the past, a low reading of RSI signifies good returns while high readings signify impending price drops.
Best RSI Settings
The best RSI settings for stock trading are actually a look back period of 2-3 days. Daily bars tend to yield the best results when used for this strategy. Weekly bars may also do well, but daily trading strategies tend to yield better results.
Day Trading with RSI
While RSI could be applied to day trading, it’s brightest in swing trading contexts. The slower and more deliberate nature of the strategy allows traders to tap out the best of the signals from the RSI.
Combination of RSI with Other Indicators
Combinations of RSI with other technical indicators bring out sharper overall performance. For even better results, we post supplementary strategies on our website, where such combinations are instituted for better performance.
We have presented here three trading strategies with the RSI, each suitable to a different style and to tastes for risk. Each has its strengths, focusing on mean reversion, upon which the first two pivot, whereas the third offers a momentum-based strategy. Remember as you go through these strategies that past results are not indicative of future results.
Implementing effective trading rules, as well as understanding the role of RSI in regard to market dynamics, may improve your trading decisions. For the trader that aims to tighten up their approach, these strategies will be valuable tools.
Call to Action
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