Testing the RSI(2) Strategy: Scaling In and Out of Positions

 |  About: SPDR S&P 500 Trust ETF (SPY)
by: Michael Stokes

I struggled with whether or not to share this strategy because of my “never share anything I would trade myself” rule (this one is very close), but in the end I decided to err on the side of the reader.

This strategy will expand on the simple RSI(2) strategy by scaling in and out of positions (as alluded to in my most recent post). To make things more interesting, I’ll assume we used 2x leveraged mutual funds from Rydex or ProFunds (which are inherently frictionless, meaning no transaction costs or slippage).

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The graph above shows the following strategy (red) vs. the S&P 500 (blue) from 2000 to present: go 100% long at today’s close if RSI(2) closes below 5, 75% long on a close below 10, 50% below 15, and 25% below 20. Go 100% short if RSI(2) closes above 95, 75% short on a close above 90, 50% above 85, and 25% above 80.

And, for the number lovers:

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Things I like about this strategy:

This strategy has dominated the markets since 2000 in terms of absolute and risk-adjusted returns.

It has performed consistently well over a large number of trades (n=1059), thereby raising my confidence that it will continue to perform in the future. And, as the graph below shows, this consistent performance includes both the long (green) and short (red) sides of the strategy, despite some long bear and bull runs in the market.

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What I like most about this strategy is how well it has managed losses (including the market collapse this year) with average drawdowns on any given day 90% smaller than a buy & hold strategy. Mind you, it has suffered some sizeable drawdowns (the worst being -28.9% in October of this year), but it has pulled out of all of them very, very quickly.

Things I don’t like about this strategy:

In the end, I opted to share this strategy because there are three things that I don’t like about it in its current form:

  1. The fact that the RSI(2) indicator didn’t work prior to about 1997 (smell an adaptive strategy coming?),
  2. It is susceptible to the same “abnormal market” collapse that bit my YK Strategy so badly in October, and
  3. It doesn’t account for intermediate indicators (which my quick tests show would even further improve the results here).

I’m reaching my self-imposed word limit for this post, so in a follow up post I’ll discuss those three issues and my solutions for each.