We’ve based many of our trading strategies around the 2-period RSI, as we feel it is an incredibly powerful indicator when it comes to signaling overbought and oversold conditions by comparing the magnitude of recent gains to the magnitude of recent losses.
As we have covered previously, the Relative Strength Index was first developed by J. Welles Wilder in the 1970s, and can be found through this simple formula:
RSI = 100 – (100/(1 + RS))
RS = average of x days up closes / Average of x days down closes
The end result is a number ranging between 1 and 100, with oversold markets indicated as it reaches 1 and overbought indicated the closer the result is to 100. While there are numerous articles, books, and other materials out there on how to use the RSI to predict short-term pricing, most are not grounded in historical test results and statistical study.
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The majority of traders currently calculate the RSI using a 14-day period. We’ve found that when you decrease that timeframe the accuracy and results begin to really show significant improvement. We’ve built many of our trading models around the 2-period RSI based on this greater reliability, enabling us to swing trade with greater success.
More specifically, as the 2-period RSI reaches 10 and below the trading vehicle can confidently be considered oversold. Likewise as it hits 90 and above, it is now firmly overbought. In our testing we’ve determined that a stock trading above its 200-day moving average is more likely to over-perform in the short-term if its 2-period RSI level has reached 2 or less. In one-day, two-day, and one-week time frames this has been proven as buyers become increasingly attracted to extremely oversold markets.
Recently we conducted a study on trading using the 2-period RSI with ETFs and proved once again how powerful this indicator can be in the short-term. We started testing with historical data from the beginning of 2006 up through June of this year, looking at every liquid ETF that had an average daily volume of at least 125,000 shares per day over the previous 21 trading days. Over the next 5 trading days we examined how these liquid ETFs performed throughout the entirety of our data set.
By breaking down the results into different buckets according to RSI levels in increments of 10, we saw clearly how the top-performing ETFs over the averaged 5-day period had the lowest RSI readings of the entire group. Incrementally, the performance decreased as the RSI bucket increased towards 100. As we reached the 60 level and above the performance of the 5-day averages became negative returns. Below are the test results:
Connors Research 2-Period RSI Study; January 2006-June 2012.
All Liquid ETFs 5-day Return Sorted by RSI.
Knowing if a trading vehicle is in one of these extreme conditions is especially helpful when buying or selling, especially for those who are actively trading on a daily basis. By using the 2-period RSI you can take greater advantage of swing trading opportunities than those offered by the traditional 14-day period RSI, and greatly increase your trading edge. Buying on low 2-period RSI readings and selling or selling short on high RSI levels will substantially increase your trading results.
In the next installment of this series, we’ll dig deeper and explore how to increase your returns further by buying on pullbacks.