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 Stocks & Commodities V. 33:06 (2023): The RSI & Price Trends by Kevin Luo
TRADING TECHNIQUES

Tweak It, Test It

The RSI
& Price Trends
The relative strength index (RSI) is well known among
technical analysts. As with all indicators, it tends to
work better on some stocks or at certain times. Can
it be modified to give better results? Well find out.
achieve significant conclusions about the application
of the RSI strategy. I applied a custom-built automated
systemIll refer to it as the softwareto run the
performance tests.
The backtesting rules are simple. A buy occurs when

T
he relative strength index (RSI) is a popular
technical indicator designed to measure the
rate of change in price movements. All RSI
values fall between zero and 100. One of the common
interpretations of RSI is that the stock is oversold
when the RSI falls below 30 and overbought when
the RSI rises above 70. The initial impression of its
application is that you buy when the stock is oversold
and sell when the stock is overbought, or go short
when the stock is overbought and cover when it is
oversold.
the RSI value falls below 30. The sell takes place
when RSI surges above 70 for the first time after the
buy. For testing purposes, the entry and exit prices
are the closing prices of the RSI signal days.
In Figure 1 Ive shown an example of a trade on
a chart of Lennar Corp. (LEN). The green up arrow
points to a falling RSI value at 28.03 on August 22,
2011. A long trade was entered at $12.71, which was
the closing price of that trading day. On January 11,
2012 the RSI moved up to 72.49 (green down arrow),

How well does

it work?
To find out how well
it works, I conducted a
large-scale backtest on
1,816 random stocks
traded on the NYSE
and NASDAQ. The
test data covered a 10-
year period from Janu-
ary 1, 2005 to August
Intrendstocks.com

31, 2014. Given the

scale of the backtest,
the output is consid-
ROY WEIMANN

ered sufficient, precise, Figure 1: trading with THE relative strength index (rsi). The green up arrow points to a falling RSI value at 28.03 on August 22,
2011. A long trade was entered at $12.71, which was the closing price of that trading day. On January 11, 2012, the RSI moved up to 72.49
and reliable enough to (green down arrow), which is above the selling level. The stock was sold at $22.25.

by Kevin Luo

Copyright Technical Analysis Inc. www.Traders.com

 Stocks & Commodities V. 33:06 (2023): The RSI & Price Trends by Kevin Luo

Copyright Technical Analysis Inc. www.Traders.com

 Stocks & Commodities V. 33:06 (2023): The RSI & Price Trends by Kevin Luo
Test No. of Total Avg.annual Percent
ID stocks P&L P&L/Grp winning
trades
1 1,816 40.87% 4.09% 68.63%
Its profitable, but
2 1,816 34.43% 3.44% 41.52% can it be improved?
3 1,816 73.71% 7.37% 49.97% The test results suggest that the trading strategy is profitable.
However, the average annual P&L results arent strong enough
4 500 129.76% 12.98% 79.50%
to convince me to trade this strategy. There could be a few
5 500 207.28% 20.72% 54.99% reasons behind this. One of them has to do with the foundation
6 100 216.34% 21.63% 83.16% of the RSI. The formula used to calculate RSI is:

7 100 360.59% 35.99% 55.39% RSI = 100 100 / (1 + RS)

8 500 86.45% 8.64% 73.76% RS = Average gain / Average loss

9 500 23.66% 2.15% 63.23% In this formula, the relative strength or RS value represents a
Figure 2: test results. Here you see the results of the classic RSI strategy and its ratio between the average gain and average loss. In a perfect
variations. and gradual price uptrend (top chart in Figure 3), the RS val-
which is above the selling level. The stock was sold at $22.25, ues accelerate (middle chart) as the price uptrend continues.
the closing price of that day. However, the RSI that was derived from RS rises initially and
During the backtesting, the software generated long trades for then slows down significantly after it reaches approximately 70
each of the 1,816 stocks and then summarized the test outputs. (bottom chart). This is because, mathematically, the equation to
The profit & loss column in the table in Figure 2 shows that the calculate RSI restricts its values to move within its range limits
strategy produced a 4.09% average annual profit & loss (P&L) of zero to 100.
for the 1,816 stocks in the portfolio (row 1). The performance This phenomenon also exists in a downtrend. When stocks
number was calculated based on an equal-weighted approach. run into prolonged trends, it tends to become problematic. Going
The same weight was assigned to each of the trades regardless back to the chart of LEN in Figure 1, you see that the RSI values
of the price of the stock. have fallen below 30 over 10 times in 2007 during the course of
its steady downtrend. Each time the stock bounced back slightly,
RSI values overreacted by jumping up. When price moved back
to its downward trend, the RSI followed and triggered oversold
There is a negative relationship signals several times. In the worst-case scenario, if a long trade
had gone through on March 2, 2007, which is the first instance
between the duration of the trend of the RSI falling below 30 on the chart, you would have been
and the performance of the RSI left with a big loss if you had followed the strategy.
strategy. The strategy is likely to
work better on shorter stock trends. But it can get better
One way to address this issue is to reduce the number of trades
during a downtrend. Another approach is to select stocks that
move in shorter trends. I conducted a second
backtest, which Ill refer to as test 2, to vali-
Price 15 date the first approach. In test 2, I applied a
14
trend-trading technique that only traded stocks
during uptrends. No trades were opened during
13
downtrends. A downtrend is recognized when
12 prices move down by more than 20% and an
60
RS 50 uptrend is recognized when prices move up
40 more than 20%. Some of you may recognize
30
20 this from Dow Theoryappreciation or depre-
10 ciation in value of more than 20%. In Figure 4
0 you see a chart of LEN, where the green shaded
100
RSI area covers an uptrend. This uptrend started
when the stock advanced 20% (the horizontal
80
60
bar identifies the uptrend confirmation) from
40
the low of the prior downtrend. The uptrend
20
came to an end when the stock fell 20% from
0 10 20 30 the trend high (the horizontal bar identifies the
FIGURE 3: TRENDS, RELATIVE STRENGTH (RS), AND RELATIVE STRENGTH INDEX (RSI). The upper chart
trend reversal). The idea is to only allow trades
shows price moving in a perfect uptrend. The middle chart shows that the RS values accelerate during uptrends. to take place within the shaded zone.
The RSI (lower chart), on the other hand, rises initially and then slows down after it reaches 70. In test 2, trades were not held when there

Copyright Technical Analysis Inc. www.Traders.com

 Stocks & Commodities V. 33:06 (2023): The RSI & Price Trends by Kevin Luo

40

Close price in dollars ($)

was no uptrend. Once the
uptrend reversed, all posi- 30
tions were liquidated at the
closing price of the day for
Trend reversal
testing purposes. The other
trading rules remained the
same. Once the stock trends 20
were isolated, trading rules
went into effect only during Trend confirmation
the uptrends.
The results for test 2 10
indicate that the strategy 2011 Mar May July Sep Nov 2012 Mar May Jul Sep Nov 2013
underperformed in this test
Uptrend Downtrend
by producing annual returns
20% Trend
of only 3.44% (row 2 in
Figure 2). According to the FIGURE 4: TRADING ONLY DURING UPTRENDS. The green shaded area depicts the uptrend. Identifying uptrends will help ensure that
summary statistics, there you place trades only during that time.
was a significant reduction
in trades. The reduction
was a result of low oversold signals (or buy signals) during some stocks with certain characteristics. You have seen how
uptrends. Such a reduction in the number of trades obviously trading during uptrends and trading stocks with shorter trends
leads to missed opportunities. From Figure 1, notice how during improve the performance of the RSI strategy. There are also
the uptrend in 2012 the RSI fell to around 50. If RSI behaves other ways to tweak the RSI to improve its performance. I
in such a way during most uptrends, raising the RSI entry encourage you to try different methods.
signal level to 50 would increase the number of trades. So in
test 3, I changed the RSI signal level from 30 to 50. All other Kevin Luo is an independent technical analysis researcher
testing conditions remained the same. As expected, the test who focuses on automated price trendrelated analysis and
return improved from 4.09% to 7.37% (row 3 in Figure 2). generation of trading strategies. He and his project partners
For evaluation purposes, I included the top 500 and top 100 developed an automated trend analysis and backtesting system
performers from test 1 and test 3. The top 500 performers in for high- and low-frequency trading. He may be reached via
test 1 generated 12.98% (row 4) while the top 500 performers email at kxluopub@gmail.com.
in test 3 produced 20.72% (row 5) return annually. The top 100
performers in test 1 generated 21.63% (row 6) while the top 100 Further reading
performers in test 3 produced 35.99% (row 7) return annually. Edwards, Robert D., and John Magee. [2007]. Technical
With three sets of comparable return figures, you can easily Analysis Of Stock Trends, AMACOM.
evaluate the performance improvement in test 3. The percent Luo, Kevin [2015]. MACD-Suitable Stocks, Technical Anal-
winning trades in test 3 were lower than that in test 1. This was ysis of Stocks & Commodities, Volume 33: March.
the result of the liquidations of trades at trend reversals, which Intrendstocks.com
were mostly small losses. See Editorial Resource Index
The second approach that is expected to improve performance
is to select stocks that typically produce shorter trends. To test See our Traders Tips section beginning on page 51 for commentary
this, I selected the top 500 stocks of the 1,816 stocks from a and implementation of Kevin Luos technique in various technical
sorted trend size list. The software pulled out the individual analysis programs. Accompanying program code can be found in
test 1 performance of these stocks and summarized the results. the Traders Tips area at Traders.com.
These are displayed in row 8 of Figure 2. The annual return was
8.64%. For comparison, the software also selected the bottom
500 stocks, or those that had the larger trends. The return was
2.15% (row 9 of Figure 2). This confirms a negative relation-
ship between the duration of the trend and the performance of
the RSI strategy. In other words, the strategy is likely to work
better on shorter stock trends.

Get creative
The RSI is an indicator that can be made into an effective trad-
ing strategy. No trading strategy works on all stocks equally
well or all the time. Likewise with the RSI, it works better on

Copyright Technical Analysis Inc. www.Traders.com

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