Last Updated on June 19, 2022 by Quantified Trading
Cutler’s RSI including backtest
The RSI is a very popular trading indicator among different security traders. But there are other variations of the RSI indicator. One of them is Cutler‘s RSI. You may be wondering what it is, and in this article, we provide you with a description and how it performs in backtests.
Cutler’s RSI is a variation of the original RSI indicator developed by Welles Wilder. It uses a simple moving average in its calculation instead of the smoothed moving average used in Wilder’s original RSI formula. Because it uses a simple moving average, Cutler’s RSI is not data length dependent, so it returns consistent results regardless of the length of the period, or the starting point. However, our backtests reveal that Cutler’s RSI is no improvement compared to Wilder’s RSI.
What is Cutler’s RSI indicator?
Cutlers’ RSI is a variation of the original RSI developed by Welles Wilder. This variation of the RSI uses a simple moving average instead of an exponential average Wilder used in his original formula. As with the original RSI, Cutler’s RSI is based on the ratio of the average upward change during trading sessions that closed higher to the average downward change during sessions that closed lower.
Cutler had found that since Wilder used a smoothed moving average to calculate RSI, the value of Wilder’s RSI depended upon where in the data file his calculations started. He termed this Data Length Dependency. By using the simple moving average instead of the exponential or smoothed moving average used in Wilder’s original formula, Cutler’s RSI is not data length dependent, and as such, it returns consistent results regardless of the length of, or the starting point within, a data file.
Apart from the minor differences in the calculation, Cutler’s RSI is also used as a momentum oscillator in technical analysis to measure the speed of price movements. Just like the original RSI, it oscillates between zero and 100, and traders use the readings to gauge the momentum of price movements.
When attached to the chart, the indicator is usually displayed in the indicator box under the price chart, and the indicator line moves between the 0 and 100 readings. A reading of 30 or lower signifies an oversold market, while a reading of 70 and above signifies an overbought market. The indicator can also show divergence from the price movements when the price movement and the indicator movement are not synchronized.
Cutler’s RSI also deviates from Connors RSI. To show you the differences we have compiled all three versions of the RSI in one chart:
In the chart above all RSIs have a seven-day lookback period. And as you can see, they all deviate pretty significantly from each other.
What is the formula for Cutlers RSI?
The RSI is computed with a two-part calculation that starts with the following formula:
Part 1: Cutler’s RS = SMA (U, n)/SMA (D, n)
RS = relative strength factor
SMA (U, n) = n-period simple moving average of U, and U = upward change on days the market closed higher
SMA (D, n) = n-period simple moving average of D, and D = downward change on days the market closed lower
Note that from the equation above, if the average of D values is zero, then the Cutler’s RS value will approach infinity, so the resulting Cutler’s RSI, as computed with the formula below, will approach 100.
Part 2: Cutler’ RSI = 100 — [100/(1 + Cutler’s RS)]
This is the formula that converts the relative strength factor to a relative strength index that oscillates between 0 and 100:
How is Cutlers RSI calculated?
Just like the original RSI, Cutler’s RSI compares the average upward change on the days marked closed higher to the average downward change on the days it closed lower. The steps for calculating the indicator are as follows:
Step1: Calculating the Gains and Losses within the chosen period: The first step is to calculate the upward change or Gain (U) and downward change or Loss (D) for each corresponding trading session within the chosen period:
U = Closenow — Closeprevious while D =0
D = Closeprevious — Closenow while U =0
Both U and D = 0, if both previous and current closes are the same.
Step 2: Calculating the simple moving averages of U and D: The next thing is to get the simple moving average (SMA) of the U and D. To simplify the calculation explanation for the SMAs, we will base the calculation on 14 periods, which is the default setting for the original RSI.
SMA (U, 14) = (Sum of Gains over the past 14 periods)/14.
SMA (D, 14) = (Sum of Losses over the past 14 periods)/14
Note that losses or downward changes are expressed as positive values, not negative values.
Step 3: Calculating Cutler’s relative strength factor (RS): This is calculated with this formula below:
Cutler’s RS = SMA (U, 14)/SMA (D, 14)
Note that from the RS equation above, when the average of D values is zero, the RS value will approach infinity, and when the average of U values is zero, the RS will be zero.
Step 4: Calculating the Cutler’s RSI: The RSI is calculated as:
RSI = 100 — [100/(1 + RS)]
As you can see, when the average of D values is zero and the RS value will approach infinity, the resulting RSI will approach 100. Conversely, when the average of U values is zero, the RS will be zero, and the resulting RSI will be zero too.
How does Cutler’s RSI work?
Cutler’s RSI works like the original RSI. The level of the RSI is a measure of the security’s recent trading strength, while the slope of the RSI is directly proportional to the velocity of price movement. The distance traveled by the RSI is proportional to the magnitude of the move.
This RSI variation also shows overbought/oversold levels in the market. It is based on the idea that when the price moves up very rapidly, it becomes overbought at some point. Likewise, when the price falls very rapidly, it is considered oversold at some point. In either case, when the indicator reaches that overbought/oversold levels, a market reaction or reversal is more likely to happen.
How do you read the Cutler’s RSI indicator?
There are different ways to use Cutler’s RSI. These are the common ones:
Overbought and oversold
As with the original RSI, Culter’s RSI can be used to identify overbought and oversold levels in the market. Readings greater than the 70 level are considered to be in overbought territory, while readings lower than the 30 level are considered to be in oversold territory. Between the 30 and 70 levels is considered neutral. But it all depends on the length of the lookback period. The shorter the lookback period, the more volatile swings in the Cutler’s RSI.
Traders use the overbought/oversold levels to time the possible end of a pullback in a trending market. When the market is overbought in a down-trending market, traders look to open short positions or add to existing ones. Likewise, when the market is oversold in an up-trending market, traders look to buy.
Cutler’s RSI also shows divergences: situations where the indicator line and the price action are not in phase. Divergence can be classical or hidden.
This type of divergence happens under two conditions:
- If the indicator makes a higher low when the price makes a lower low: This gives rise to a bullish classical divergence and indicates a likely upward reversal after a prolonged down move.
- If the indicator makes a lower high when the price makes a higher high: In this case, you have a bearish classical divergence, which indicates a likely downward reversal after a prolonged price rally.
This kind of divergence often happens in a trending market and may be a better signal to identify the end of a pullback than the overbought/oversold levels. A bullish hidden divergence occurs when an uptrend price correction results in a higher low compared to the last price correction, while Cutler’s RSI results in a lower low compared to the prior correction. This might be a good signal to go long or add to existing long positions.
On the other hand, a bearish hidden divergence occurs when a downtrend rally results in a lower high compared to the last downtrend rally, but RSI makes a higher high compared to the prior rally. This might be a good signal to go short or add to existing short positions.
Cutler’s RSI vs. the original RSI: What is the difference?
The original RSI developed by Welles Wilder makes use of the smoothed moving average or exponential moving average in calculating the average Gains (U) and Losses (D) within the chosen period. Thus, RSI values become more accurate as the calculation period extends.
Cutler’s RSI, on the other hand, uses a simple moving average to calculate the averages of U and D, instead of the exponential or smoothed average above used in the original RSI. Using the simple moving average removes what Cutler termed Data Length Dependency, which is the fact that Wilder’s RSI values become more accurate as the calculation period extends. Since Cutler’s RSI is not data length dependent, it returns consistent results regardless of the length of, or the starting point within, a data file.
Backtest of Cutler’s RSI
How does Cutler’s RSI perform? There is only one way to find out and that is via backtests.
We backtest Cutler’s RSI on S&P 500 (SPY):
We like to start backtests with an optimization. Why? Because we get to see how dependent that indicator or strategy is based on the lookback period and the buy and sell thresholds.
We have provided a table below that has two different parameters: the number of days in the lookback period and the different threshold levels for when we buy and sell.
Our optimization table looks like this:
The row marked in blue shows the results of using a 6-day lookback period and buying SPY when Cutler’s RSI level crosses below 40 and selling when it rises above 60 (100-40). The profit factor shows that this was the best strategy among those settings shown in the screenshot above.
Amibroker and Cutler’s RSI
The above optimization was done in Amibroker. Unfortunately, the code is not supplied by Amibroker. However, we coded Cutler’s RSI and you can purchase the code plus code for all free trading strategies we have published since 2012. For a full list of our strategies (and many come with Tradestation code) please press the green banner below:
The best settings for Cutler’s RSI
Let’s finish this article with a specific backtest of Cutler’s RSI. Unlike Wilder’s RSI and Connors RSI it’s best to use a bit longer lookback period for Cutler’s RSI.
We use a five-day lookback period, a buy threshold of 25, and we exit when today’s close is higher than yesterday’s high.
This is the equity curve and the drawdowns (for SPY):
Cutler’s RSI performs well, but our main conclusion is that it’s both easier and better to stick to the old and loyal Wilder’s RSI.