INDICATORS
One Of The Best Short-Term Indicators?
One Of The Best Short-Term Indicators?
by Larry Connors and Ashton Dorkins
The relative strength index has been heavily used since its creation, but does it work for you?The relative strength index (RSI) is one of the most popular tools used by traders. As such, there are many books and articles written showing how to use RSI. Unfortunately, most of the published material doesn't show any statistical evidence to support the indicator's performance. This is surprising, considering how popular the RSI is and how many traders rely upon it. Before using any indicator, it is important to test if the indicator actually works -- in other words, does using a particular indicator give you an edge versus a benchmark, like an index or the average performance of all stocks?
Our statistical studies helped determine that RSI is indeed one of the best indicators available -- when used correctly. 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 time frame, you start seeing some very impressive results. Research shows that the most robust and consistent results are obtained by using a two-period RSI, and over the years, we have built successful trading strategies and systems that incorporate the two-period RSI.
This article is going to teach you a very simple, yet effective, quantified trading strategy using the two-period RSI. Before getting into the actual strategy, here's some background on the RSI and how to calculate it.
THE RELATIVE STRENGTH INDEX
The relative strength index (RSI) was developed by J. Welles Wilder in the 1970s. The RSI compares the magnitude of a stock's recent gains to the magnitude of its recent losses.
A simple formula (Figure 1) converts the price action into a number between one and 100. The most common use of this indicator is to gauge overbought and oversold conditions. Simply put, the higher the number is, the more overbought the stock is, and the lower the number is, the more oversold the stock is.
Most software and websites do the calculation for you, but as mentioned earlier, the most common/default setting is usually 14 periods. That means you will need to change the setting in order to use the following strategy. If you are unsure how to change the default setting, contact your software vendor.
...Continued in the November issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the November 2007 issue of Technical Analysis of
STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2007, Technical Analysis, Inc.
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