The relative strength index or RSI is an incredibly powerful indicator, arguably one of the most powerful currently available to traders. Originally published by Welles Wilder in 1978, the RSI is a momentum oscillator that measures a stock or ETF’s overall gains against its losses throughout recent trading activity. Unlike the 14-period duration RSI that most traders are familiar with, we’ve discovered through historical research that a shorter, 2-period duration can be a steady indicator of overbought and oversold conditions.
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Knowing when an ETF or stock is oversold and advantageous for buying, or when it’s overbought and ready to be sold is invaluable for short-term traders who are active in the market on a daily basis. By using the 2-period RSI traders can secure the maximum performance of their trades.
The 2-period RSI has proven to be especially effective when used to trade leveraged ETFs.
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RSI can be calculated as RSI= 100 – (100/1+RS) where RS or relative strength equals the average gain divided by the average loss of the investment. This formula results in a number ranging from 0-100 along a scale from absolute overbought conditions on the low end, to completely oversold on the high end. To clarify: the lower the RSI, the more oversold, the higher the RSI, the more overbought. In looking at historical market results, an RSI calculated with a shorter period will return more reliable data with greater opportunity to take advantage of a swing than the traditional 14-period RSI.
As 2-period RSI levels reach 90 and above, most ETFs can be considered firmly overbought. As the reading hits 10 and below, the vehicle is solidly oversold. Oversold 2-period RSI ETFs under 10 have historically shown positive results over a week-long period, while the opposite holds true for those over 90. Popular leveraged ETFs like Direxion Daily Small Cap Bear 3x Shares (TZA), ProShares Ultra S&P500 (SSO) and ProShares UltraShort Oil & Gas (DUG) have all displayed extreme overbought/oversold conditions in the last 3 months that can be clearly measured with the 2-period RSI.
Using these signals to buy and sell leveraged ETFs with a corresponding RSI level can result in impressive returns when traded with a quantified strategy. Let’s take a look at some recent market activity to highlight how powerful an indicator the 2-period RSI can be when compounded with the leveraged ratio of capital that these ETFs hold.
Direxion Daily Energy Bear 3x Shares (ERY) opened May of 2012 in dramatically oversold conditions, closing on 5/1/12 at 9.48 with a 2-period RSI of 0.21 and signaling an opportune moment for buying. Within a week ERY had rebounded to 11.26 by the close on 5/8/12, and was now in overbought territory with a 2-period RSI of 96 after a 21% gain.
Direxion Daily Financial Bear 3x Shares (FAZ) was trading at 22.84 in overbought conditions by 4/23/12 when the leveraged ETF registered a 2-period RSI of 90.68. By recognizing the signals traders could have shorted FAZ for a significant gain as it dropped to 20.82 four days later on the close of 4/27/12 with a new oversold 2-period RSI of 7.83.
Since the RSI reading of a leveraged ETF has to factor in what its underlying holdings are, the tolerances for overbought and oversold conditions of the 2-period RSI are less extreme than those found in the stock market. According to our research, an RSI of 30 and below connotes an oversold market with a leveraged ETF, while a reading of 70 and above is enough to determine overbought conditions.
Leveraged ETFs can offer particularly strong performance when traded in the most extreme oversold conditions when the 2-period RSI is under 10. Our test results have also shown that leveraged ETFs with 2-period RSI levels under 10, 5, 2 and 1 have historically shown strong positive gains over a week-long trading period. Historically these funds have rallied sharply on the short-term and have offered a serious edge to informed traders.
Speculating market conditions with a leveraged ETF can offer amplified returns and increased performance. While losses can be magnified to just as extreme of a degree when traded improperly, using the 2-period RSI can help traders lock in on the most favorable trading conditions and execute their trades alongside their preferred entry and exit strategies.
To learn more about trading leveraged ETFs with the professional trading strategies developed by Larry Connors and Connors Research, click here to watch a free video preview of The 1st Leveraged ETF Trading Strategies Workshop.
Larry Connors is CEO of Connors Research
Cesar Alvarez is Director of Research of Connors Research
Joshua Glasgall is Editor in Chief of Connors Research