Trading Idea #025 – RSI Monthly Bounce 1

This RSI trading system was inspired by my last system, Trading Idea #024, which is a mean-reversion system on a monthly timeframe.  As I built and tested that system, I wondered what would happen I just took a one-bar trade on a monthly chart based on 2-period RSI stochastic coming out of oversold territory (over 10%). In other words, a bounce from oversold. 

The general thinking here is that as price moves out of oversold, we are just jumping on the momentum train and picking up a quick and easy win.  The reasoning behind the monthly timeframe, as I have stated elsewhere, has to do with the holding period constraints (minimum 30 days) with which I must comply.

One month, in and out. That’s it!  I will be working with equities, as I do not have enough historical data yet to try this on futures.

Phase 1: Plan & Design

1. Trading Idea

The big idea is to capture the first month’s move and then get out:

  • 2-period RSI for entries
  • Long entries only  
  • Entry on the first day of the month
  • Exit on the first day of the next month

Here are the entries:

Long:

  • RSI(2) has moved out of oversold, using the 10% line as our oversold threshold
  • Enter next bar at market
Enter when RSI closes above 10; exit after one bar

2. System Definition

Indicator:

RSI, 2 period

Parameters:

Input(Default)Data TypeOptimizable?Comments
Risk_Capital(2500)IntegerYesAmount of capital required for each trade
Leverage(4)IntegerYesMultiplier for risk capital
Stop_Loss_Offset(.02)IntegerYesAmount subtracted for the latest monthly Low price for setting our stop order

Initial Capital:

  • $50,000

Leverage:

  • 4:1

Position Sizing:

  • Risk_Capital = $2,500 per symbol (purchasing power = $10,000)
  • Number of shares = Risk_Capital / Latest Close Price * Leverage (rounded down)

Entry:

  • Long:
    • RSI >= RSI_Oversold and
    • RSI [1 bar ago] < RSI_Oversold

Stop:

Set stop to $.02 below latest low

Exit(s):

  • Exit long position after 1 bar

Profit Target:

  • None

Challenges: None

3. Performance Objectives

The system will meet the following objectives:

ObjectiveGoal
System Type (trend, mean-reversion, day, swing, etc.)Mean-reversion
Risk of Ruin0%
Profit Factor>1.5
Win Percent> 50%
Max Drawdown %< 35%
Profit/Drawdown Ratio> 2.0
Ready Date2021/12/31

This idea is S.M.A.R.T.: Specific, Measurable, Achievable, Realistic, Time-bound

4. Market Selection

Markets:

EnergiesCurrenciesFixed IncomeAgricultureMetalsSoftsIndexesEquities
X

Instruments:

Market SectorInstrumentSymbolComments
EquitiesRandom equities from S&PAAPL, ABT, ADBE, ADI, ADM, ADP, ADSK, AEE, AEP, AES, AFL, AIG, ALL, AMAT, AMGN, AON, APA, APD, AVY, AXP, AZO, BA, BAC, BAX, BBY, BDX, BEN, BK, BLL, BMY, BSXI selected all symbols starting with ‘A’ and ‘B’ that have been part of the S&P 500 since 2000.

Chart Type, Timeframe, Session, Time Zone:

AttributeValueComments
Chart TypeRegular CandlestickCharting is only useful for validating entry and exit signals
Timeframe / Interval(s)Monthyl 
SessionRegular 
Time ZoneExchange 

Phase 2: Build

5. Manual Test

Pass.  The handful of random instruments I selected seemed to work just fine.

6. Build

Process Diagram

RSI trading

Comments:

It does not get much simpler than this. 

7. Unit Test

Complete?

Phase 3: Test

8. Optimization

We are not optimizing any parameters for this system.

9. Walk-Forward Analysis

For this RSI trading system, I performed walk-forward analysis by placing all symbols in a portfolio and then run a backtest, from January 1999 to December 2020.  The reason for the long backtest period is two-fold:

  • I am working with monthly charts, which means fewer signals
  • The more data used for testing, the better

Personally, I would like even more data than that, but that would complicate things too much, given the amount of time I have to develop and analyze this system. Below is a table of the symbols tested.  I selected only those with a profit factor of greater than 1.5, which leaves me with 14 to advance to incubation.

Here are some additional thoughts:

  • Profit Factor for this set of instruments, through December 2020, is 1.14. As a portfolio of random symbols, this RSI trading system does not perform well.
  • Average number of trades per symbol: 12, which is less than one trade per year
  • Highest number of open positions: 20; this would require $50k in capital ($2,500 * 20), which will have a bearing on Monte Carlo analysis

10. Monte Carlo Simulation

There were not enough trades for some of these symbols (as few as 2 trades in 20 years) to perform a reliable Monte Carlo analysis, so I took all trades for those 14 symbols, treated it as a portfolio, and ran the Monte Carlo program.  I used a starting equity of $50k, since that is maximum amount I need available for trading.  Here are the results:

Monte Carlo fails because the Return to Drawdown ratio is less than 2.0.  Even though it failed, I will look at the incubation period (2021) for academic purposes.

11. Incubation

Although the system has failed, I took the 14 symbols and put them in incubation.  Here are the resulting trades:

There was not a lot of trades produced by this system and it performed poorly. This would not have passed incubation.

Phase 4: Deploy

12. Production / Portfolio Assignment

We did not make it this far.

Trading System Result: FAIL

Notes and Commentary

This RSI trading system failed, but I cannot know until I try it. I have built several systems like this, where I am bouncing out of oversold using a very short RSI.  This system has some problems, but here are my top three:

  • Too much capital required at certain times
  • Low profitability
  • Infrequency of trades

This is what I have to deal with on monthly timeframe. I think that maybe, just maybe, mean reversion is less meaningful at this level.

Continuous Improvement Department:

Overall, this system idea is okay, but not worth it. Here are some thoughts about what I can do with what I learned:

  • Step away from the quick exit and try longer holding periods
  • Filter for symbols with only a positive earnings-per-share (EPS)

I am finding it difficult to get creative in the longer timeframes, but I have some thoughts around breakout systems.

This is my last system for 2021. I have built and tested 25 systems and have had 4 pass the criteria for a potential winning algorithmic trading system. This is a 16% success rate, if you are keeping score.  I expected much less, to be honest.  Regardless, I will keep building these systems and publishing as often as possible. I suggest subscribing to my newsletter to get the latest system ideas in your inbox as I publish. As always, thank you for reading and following along on my journey.

Do you have a RSI trading or any other idea that you want me to put through our process to see if it would make a valid system?  Leave a comment below and we can discuss.

Sources/References

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