There’s a lot to be said for keeping it simple when it comes to trading. Indeed, it is possible to have a trading system with just three easy to understand and easy to follow rules that will allow you to outperform the market. Moreover, this particular strategy produces a high percentage of winning trades with holding periods that average little more than a week — both sought-after qualities by most traders.
Research into short-term trading indicates that taking advantage of the market’s tendency to become overextended, regardless of direction, is the easiest, most effective path toward success as a trader in equities and the stock indexes that they compose.
The trading system or method presented here — the RSI(4)
RELATIVE STRENGTH SETUP
A helpful indicator for short-term traders is the relative strength index (RSI). Devised by Welles Wilder in the 1970s, the RSI is a popular and commonly used technical indicator — it falls into the class of indicators typically referred to as oscillators — that traders use to determine whether a market is overbought or oversold. The RSI works from a scale of 0 to 100, with 0 representing an extremely oversold market and 100 representing an extremely overbought market.
Oversold markets are typically markets that are in downtrends and feature more sellers than buyers, with the excess supply working to depress prices. Overbought markets, on the other hand, tend to have a surplus of buyers. Overbought markets, then, tend to be markets that are in uptrends, with demand driving prices higher.
It has long been a popular, and successful, trading strategy to buy oversold markets and to sell overbought markets. And oscillators like the RSI have been invaluable tools in this approach. The version of the RSI used as part of the RSI(4)
A 14-day look-back period simply allows too much noise for the trader looking to work on a time frame only half — or even a third — as long.
There is a bit more to the trading system, but not much. Remember that part about simple being better?
Here are the particulars. The RSI is set to four periods rather than 14. The RSI fluctuates between 0 and 100, but the levels we are interested in are the oversold level when the RSI falls to 25 or less and the overbought level when the RSI rises to 65 or more. When the market closes with an RSI of less than 25, we buy that close. We hold the position until the market closes with the four-period RSI above 65 or more, and exit on that close.
To filter out the bullish trends, long trades are taken only when the S&P 500 index is above the 200-day moving average. We have found that oversold markets that also are under the 200-day moving average have a bad habit of becoming still more oversold. So we stick to buying dips in strong markets.
FEWER TRADES, MORE WINNERS
Tested on the E-mini S&P 500 index futures contract from September 1997 through November 2006, a period that included a bull market, a boom market, a bear market and a low-volatility recovery, the RSI(4)
Here were the results of the RSI(4)<25:
Number of Trades: 55
Percentage Winners: 75%
Average % Profit: 0.96
Total E-mini Points: 655.50
Average Hold Duration in Days: 5.2
“In and out” shows a relatively typical trade entry and exit. Although the trades are somewhat short in duration, they are not excessive in number. The RSI(4)
The system also has another important quality: a high winning percentage. There are many reasons why having a high win rate is important, but one of the most important is simply psychological. Trading systems with high win rates and minimal drawdowns are simply easier to stick with because the sensation of trading — the day-in, day-out experience of placing orders, getting into positions and exiting them — is largely positive. This can be a helpful contrast to other sorts of trading systems that have win rates that are closer to 50% or even less as in the case of many trend-following systems that, while successful over time, often require nerves of steel to abide by.
Lastly, the most obvious point: 655.50 vs. 470.25. The RSI(4)
All this is in a simple system that is long-only, meaning you did not have to sell the market short at all to make money, even including the bear market years of 2001 and 2002.
It’s important to note that this performance also has held through the recent extended period of consolidation that has riled the market. The RSI(4)
PULLBACKS INTO PROFITS
Traders can use the RSI(4)
But what is almost more important than the method itself is the understanding about how markets really work that simple, effective trading strategies like the RSI(4)
It’s also clear — and supported by millions of simulated stock trades from the mid-1990s to the present — that while pursuing this historical bias to the upside, markets from time to time pause or even reverse course temporarily as profits are taken. The good news, though, is that over time, these pauses and pullbacks are true opportunities that can help turn average speculators into successful traders, but only if you know how to identify them and have the wherewithal to take advantage of the opportunity.
David Penn is the editor of Tradingmarkets.com and PowerRatings.net. Larry Connors is founder of Tradingmarkets.com and Connors Research LLC. He's also the author of “Street Smarts” (with Linda Raschke) and “How Markets Really Work.” Reach him at firstname.lastname@example.org.