Every great trader has a bag of tricks. Each of these opportunities, if you will, is a predefined market condition signaling when to enter a trade and when to close it. One that has been in my bag for awhile is buying the SPY when the Relative Strength Index (RSI) indicator hits 30. My MO is to keep a tight stop and refrain from getting too greedy. Which means what, exactly? I have always based my approach to this trade on a hazy amalgam of instinct and experience, but in the name of maximizing the return I decided to systematically explore the possibilities.
So I backtested (of course) the following study. With a balance of $10,000 I purchased the SPY every time the RSI hit 30 from 1993 to the present. I then played with different closing trades, first setting the stop loss at 3% and varying the profit gain (see the top table) and then varying the stop loss and setting the profit gain at 11% (bottom table).
|3% Stop / 7% Close||3% Stop / 11% Close||3% Stop / 15% Close|
|Profit & Loss||$12,841.55||$25,568.21||$-9,871.17|
|1% Stop / 11% Close||2% Stop / 11% Close||5% Stop / 11% Close|
|Profit & Loss||$14,735.41||$12,894.22||$18,826.06|
I also included in the study the Compound Annual Growth Rate (CAGR) of the trades to allow for comparison, though most of the trades only lasted a few weeks. Using the RSI indicator to trade the SPY is not a comprehensive, long-term strategy—it’s merely an opportunity to capitalize on when certain conditions arise.
In terms of profit and loss, I got the best results when I had a stop loss of 3% and a profit gain of 11% (you can view the trades here). If I had been greedy and held out for 15% I would have lost a lot of money. You will also notice that—as is the case with most directional trading—my success rate was darn close to 50% for every trade. Good directional traders understand that their probability of success is always 50-50, and they make their money by knowing when to cut off a losing trade and when to close out a winning trade.
Some Basic Observations
I also tried backtesting the short side of the RSI. That is, selling short the SPY when the RSI reading crossed the upper limit of 70. Though I know this trick works in some cases, I could not make it work for the SPY and every test ended in a loss. I suspect that this approach might work best for high beta individual stocks.
Most of you know me as an options trader, but I conducted this study for two reasons: (a) to inform one of my less public strategies (I like to trade multiple strategies) and (b) to see if I could use a naked RSI number in my put credit spread trading. As for the latter, I could not identify any easy ways to use the RSI number in credit spread trading strategies though I do use the general trend of the RSI to increase the odds of success—more on that in a different post. The gang over at Tastytrade did a nice study on RSI and options trading and the following video is worth a watch.
The RSI indicator trade is one you might make only a few times a year. Think of it as an easy way to pick up a few percentage points in your portfolio in a few weeks. You just need to watch for the right market condition and then seize the day.
Another one for the bag of tricks. Enjoy.