Many indicators are often representations of similar measures. I prefer to not get bogged down with multiple measures of a trend. To keep things simple, I typically monitor price and volume, MACD, RSI, and sometimes the Stochastics. While the MACD can help traders judge the strength of a trend and also identify when a new trend is beginning, the RSI is often used to help with timing, i.e., when to get in, and when to get out of a trade.
Because of its simplicity, the Relative Strength Index (RSI) is one indicator that has always made intuitive sense to me. The calculation is simply the average of x days up closes / x days down closes. What traders have often differed on is what average to use. The default with most charting software is a 14 day average. However, several bloggers have advocated, or at least discussed using a 2 day(period) average. IÂ know Bill Rempell, Bullish Jim, and Marlyn from Filtering Wall Street (no longer being updated) have all presented trades using the 2 day RSI.
Some new researchÂ shows the benefit of using a 2 day RSI average. In the November issue of Technical Analysis of Stocks and Commodities, an article by Larry Connors and Ashton Dorkins describes the results generated during testing more thanÂ 8,000,000 trades from January 1, 1995, to December 31, 2006. The average one week percentage gain or loss for all stocks during the period tested was +0.25%.
After quantifying overbought and oversold conditions (RSI above 98 is overbought; RSI below 2 is oversold), their research showed that stocks with a 2 period RSI below 2 averaged a gain of +0.88% one week later (beating the benchmark average by more than 3:1). Conversely, stocks that were overbought with a 2 day RSI greater than 98 lost money (-0.17%) one week later as well as underperforming the benchmark.
The implications of this research are crystal clear: Traders should use a 2 period RSI if they want the indicator to actually give them an edge.
I have been experimenting with the RSI(2) for about a month and haveÂ anecdotally observedÂ several characteristics of the indicator.Â
- First, it seems to work better with stocks that are trending up or down and making regular peaks and valleys.Â
- When applied to a stock in an uptrend,Â it will do a good job of identifying a buying opportunity, but does notÂ seem to performÂ as wellÂ asÂ a sell signalÂ because goodÂ stocksÂ seem to stay overbought for longer than they stay oversold.Â Â
- It seems to work especially well whenÂ the RSI(2) is 2 or lessÂ and the stock is sitting nearÂ support, whether it be a trendline or moving average.Â
- The RSI(2) does not seem to work well for stocks that have fallen off of a cliff or are in a sharp downtrend. In these cases,Â stocks can stay oversold for long periods of time before bouncing.
WhenÂ I find stocks which are oversold on the RSI(2) and meet the above criteria, I will post the chartÂ so that we may examine the effectiveness of the indicator.
2006. Connors, L. and Ashton Dorkins. “Does the RSI give you an edge?” Technical Analysis of Stocks and Commodities. 48-52, November, 2007.