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The indicator RSI(2) has been garnering a lot of attention from the blogosphere. A number of fellow bloggers (Woodshedder, IBDIndex, Bill Rempel and Dogwood come to mind) have been doing all sorts of nifty stuff with it and I recommend that TA-oriented folks get plugged into that discussion.

In this report, I’m going to test the indicator in its simplest form and look at how its performance has evolved over time (and why trading it as a static strategy might be a dangerous approach).

I you're unfamiliar with RSI(2), read this primer. The short Relative Strength Indicator (RSI) used here (2-day instead of the customary 14-day) is measuring how overbought/oversold the market is in very recent history. See sample chart below (RSI in top pane).

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I’ve read a lot of different interpretations of RSI(2), but in its simplest form, traders go long when the RSI is very low (i.e. oversold) and short when it’s very high (i.e. overbought). In the graph below, I’ve assumed a trader went long the S&P 500 at yesterday’s close whenever the RSI closed below 10 and short whenever it closed above 90, from 2000 (frictionless with no return on cash).

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And for the number-lovers:

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Clearly, since the beginning of this decade the strategy has been very predictive of next day returns. I especially like these results because (a) for an “extreme” contrarian indicator, it triggers fairly frequently (about 24% of all days), and (b) despite the fact that most short-term contrarian indicators failed miserably in October/November 2008, this approach weathered the storm well.

But there are also things that I don’t like. First, the graph above makes it hard to see, but the strategy went through a long dry spell around 2004 and 2005 where it was very much not predictive of returns. Compounding that is the fact that prior to about 1997; RSI(2) didn’t work at all as a contrarian indicator.

See graph below, which has the same trading rules as above, from 1970.

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Prior to about 1980 (i.e. left of first dotted blue line), the indicator worked exactly opposite as it does today (i.e. right of second dotted blue line). Results in between those periods were mixed. This is very reminiscent of the evolution of daily follow-through that I’ve discussed a number of times on this blog.

I do think RSI(2) has wings in today’s market. I’ve been meaning to add an “extreme” short-term OB/OS indicator to the State of the Market report, and for now, RSI(2) will be it (expect to see it in the next report). The entire SOTM report is adaptive meaning it should detect if this indicator stops working in the future.

But I would be hesitant to trade the RSI(2) in the simple form I’ve described here as a static strategy. I think performance prior to the late 1990s and even at points in this decade indicate that at some point, this strategy could revert to its old ways.