Varadi’s DV2 vs. Wilder’s RSI2: Trading the Divergence

In case you hadn’t noticed, there is a new sheriff in town, and his name is DV2. The DV2 is a new indicator developed by David Varadi of CSS Analytics blog fame. For the best overview of how this indicator works, including how to calculate it, see this series of posts.

While there has been a great deal already written about this indicator (geeks are easily excited by such things as new formulas), one aspect that has been mentioned but not yet reviewed in the quant blogosphere is that a divergence between DV2 and RSI2 may allow forecasting of future returns.

The Method:

Entry: Go long the SPY if the difference yesterday between RSI2 and DV2 < 5 and the difference today > 5.

Exit: An n day exit (geek speak for a time based exit) will be used.

All trades are opened and closed at the close, and no commissions were used. While I prefer testing opening and closing trades on the open, my rate-of-change calculations were already set up using the closing prices.

The Results:

The blue line illustrates the average daily change after buying the SPY when the difference between RSI2 and DV2 is greater than 5. The red line is the average daily rate-of-change of the SPY, calculated using all of its history.

The graph demonstrates that there is an edge. In terms of efficiency (profits per day) it appears that the edge is strongest over the next 4 days following the divergence.

Summary:

The results show that there can be situations where RSI2 has risen to extreme heights without confirmation from DV2. Traditionally, a high RSI2 would have signaled to sell a long position or go short. The addition of DV2 can help traders judge when the market might have room for additional upside, despite an extreme RSI2 reading. This phenomenon is best illustrated by looking at a chart of the two indicators with the SPY (below).

The green arrows show all raw entry possibilities. There were many times over the past several months were DV2 did not confirm RSI2, and a divergence developed. The divergence can alert traders to the possibility of more upside.

Further Research:

In the future I will examine what happens when the opposite divergence occurs (DV2 is higher than RSI2). Also, an extreme divergence where (RSI2-DV2)>50 will be examined to determine any implications for forecasting future returns.

Should anyone find the DV2 to be a valuable addition to his toolbox, Mr. Varadi will be releasing the DV2 along with a whole suite of indicators, including a super-charged DV2, in the very near future. Be sure to visit his blog for more information.

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The system will be selling after the recent strength, and no new purchases will be made.

On the open the system will be selling Advanced Energy Industries, Inc. [[AEIS]] , Harris Stratex Networks, Inc. [[HSTX]] , ZHONGPIN INC. [[HOGS]] , and Camden Property Trust [[CPT]] .

Have a great day trading!

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On the open, the system will sell Macquarie Infrastructure Company LLC [[MIC]] , ING Prime Rate Trust [[PPR]] , and Ener1, Inc. [[HEV]] .

The system will be buying [[CHIP]] , The Hain Celestial Group, Inc. [[HAIN]] , and Flowers Foods, Inc. [[FLO]] .

Good luck today!

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It has been four months since my last confession. Life has been out-of-control busy, and as soon as I get home from work, I’m punching stuff into spreadsheets, blogging, working on my coding skills, and backtesting. It seems I have little time to do anything other than work. When I’m home, if I’m not in front of a computer, then it feels like time is being wasted that could be spent on the next formula, the next system, or the next blog post. Then, there are my children, and my wife. Life is just go go go right now, every day, including the weekends.

But it almost HAS to be that way, if you ask me. How can I expect to do well trading, when I am competing against people who have 8+ hours a day to do this as their day job? It just happens that my 8 hours a day often come at night or on the weekends.

I am so sick of writing about the Power Dip system. I have sliced and diced and chopped and shredded that system six ways from Sunday. I have tried to spare the readers from most of the process. A woman once said, “I just wanted to hold the baby, not birth it,” and I figure that is how many of my readers are feeling about now. (Although my traffic has not really suffered…Maybe it hasn’t been too awful?)

I hope watching 5 months of real-time trading and tracking of a system has been a helpful exercise. There is a lot to consider when trying to get actual results to come close to matching backtested results, and I have not even mentioned some of the more mundane issues such as order routing or using the best order types for the situation. I wanted to write more about percent-risk position sizing, and how that can be combined with limiting the max number of positions to increase profits and decrease drawdowns. I intend to move these specific discussions onto the Power Dip forum. That way, only those who are interested will be subjected to these esoteric issues.

So I haven’t had time to write as many in-depth blog posts as I used to. My experience is that life moves in cycles, just like everything else does. I’m hoping that I will soon be entering a cycle where I will have more time for writing about a variety of different ideas, systems, etc. Part of gaining more time is learning to do things more efficiently, and as I’m becoming more proficient at coding, theoretically I should have more time to write about what I uncover in my testing.

I have recently quit trading the best short-only system known to man. No one knows about it, except for me and a good friend (who happens to have co-developed the Power Dip). The damn system has returned over 100% a year, consistently, over the past 10 years. I quit trading it after a 5% drawdown persisted for a month. Feel free to call me a pansy, or insert your “P word” of choice. As much as I want to be able to trade it, it just didn’t fit my personality. The damn thing made me nervous as hell, every day. Anyway, that is a good topic for an upcoming blog post. The system must fit one’s personality, goals, routines, and lifestyle.

Okay, this is all for now. I have wasted enough time on this confession and have orders that need to be entered for tomorrow.

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For the week, [[SPY]] was down -1.88% while the Power Dip gained 0.22%.

Despite beating the S&P500, it was a tough week for the system. The gap-down on Friday morning resulted in 3 positions getting stopped out:  Resource Capital Corp. [[RSO]] , Republic Airways Holdings Inc. [[RJET]] , and [[VVTV]] .

It was very difficult to buy the gap-down, but most who did were rewarded. For example, [[KERX]] was picked up on the open and closed Friday with a 11.4% gain. ZHONGPIN INC. [[HOGS]] was purchased as well, and the position closed up 2.4%. (Can we just ignore [[CHIP]] , also purchased Friday morning but closed down 2.4%, effectively canceling out HOGS?)

The system will start Monday will 6 positions, and will add the following 4 positions on the open.

Gray Television, Inc. [[GTN]]

Macquarie Infrastructure Company LLC [[MIC]]

Pier 1 Imports, Inc. [[PIR]]

Advanced Energy Industries, Inc. [[AEIS]]

And below is the egregiously long spreadsheet. Note that the average trade has been cut in half over the past several weeks. This fluctuation should be within a normal range. As more trades are made and closed, the fluctuations will stay within a tighter range across the key metrics. This behavior is best described by the probability theorem, the Law of Large Numbers.

I’m realizing as I try to publish the spreadsheet that it has gotten so large that WordPress doesn’t seem to like it. Therefore, I can only post the most recent part of it, along with top part that calculates the metrics.

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Wow, today will be a difficult day to be in dip-buying mode.

On the open, the system will sell [[ADAT]] .

It will then purchase [[CHIP]] , [[KERX]] , and ZHONGPIN INC. [[HOGS]] .

Have a great day trading!

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For the month of September, the system was up about 130 bucks, to $108,615.36 or .001%, while [[SPY]] was up just over 3%. The moves the indices have been making are just insane. At this pace, the S&P500 is on track to return 100%, annualized. Keeping that (unsustainable) fact in mind, I’m not that concerned about the relative under-performance of the Power Dip system.

For Thursday, there are no sells, only buys.

On the open, the system will purchase Resource Capital Corp. [[RSO]] and ING Prime Rate Trust [[PPR]]. These purchases will leave the system with 7 positions.

Good luck trading today!

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