Last Updated on June 19, 2023
Traders always want to have a Holy Grail trading strategy or indicator that can allow them to make all the money in the shortest possible time. While such indicators do not exist, the ADX and RSI are among the best indicators for short-term trading. What are they?
The RSI, ADX, (and IBS). These technical indicators are good for short-term mean-reversion or trend-following strategies. They complement each other. RSI and ADX are good for short-term reversals, and opposite, ADX is a quality indicator for trend-following strategies.
Let’s look at these indicators, and at the end of the article, we make backtests of RSI & ADX trading strategies.
What is the RSI & ADX Trading Strategy?
TheRSI, ADX trading strategy refers to any strategy that is based on these three — RSI, IBS, and ADX — which are among the best indicators for short-term trading.
- ADX indicator backtest (Strategies – does it work)?
- How the RSI indicator works (RSI trading strategies)
- The internal bar strength (IBS) indicator
These technical indicators are good for mean-reversion or trend-following strategies. For example, short-period RSI and IBS are perfect for mean-reversion trading strategies because they can show price momentum and overbought/oversold conditions in the market
On the other hand, the ADX is a quality indicator for trend-following strategies. The indicator can be used to identify when the market is trending in one direction, even though it does not indicate the direction of the trend, and it can also show the trend’s strength.
Backtesting results show that these three indicators perform well for short-term trading, which is why we call them the Big Three. They are popular indicators that are available on most trading platforms. You can use them to create and optimize trading strategies that you can easily convert to trading algos.
What is the RSI indicator?
The relative strength index (RSI) is a momentum indicator used in technical analysis. It shows the speed and magnitude of a security’s movement by measuring gains and losses over a given period. RSI was developed by Welles Wilder, who first introduced it in June 1978 in a magazine called Commodities (now Futures).
The value of RSI oscillates between 0 and 100, so it can be a maximum of 100 and a minimum of 0. But it rarely gets to those extremes. Generally, values above 70 suggest an overbought market condition, while values below 30 suggest an oversold market condition.
RSI also gives the divergence signal. A bullish divergence occurs when the price sets a new low while the RSI doesn’t, or vice versa. It is considered a buy signal. A bearish divergence occurs when the price sets a new high while the RSI doesn’t, or vice versa. It is considered a sell signal.
Backtesting results indicate that shorter timeframes work best for the RSI when trading stocks. In fact, the best results were obtained with RSI periods of two and three days. But don’t take our word for it. You have to formulate your own strategy and backtest to know the period that works best for the security you want to trade.
What is the ADX indicator?
ADX stands for Average Directional Movement Index, a component of the Directional Movement System developed by Welles J. Wilder and introduced in 1978. This system attempts to measure the strength of the price trend in positive and negative directions using the DMI+ and DMI- indicators along with the ADX.
The system consists of three components:
- The Plus Direction Indicator (DMI+): rising values indicate that the uptrend is gaining momentum
- The Minus Direction Indicator (DMI-): rising values indicate that the downtrend is gaining momentum
- The ADX: measures the strength of the trend based on the two above
The ADX is considered a “non-directional” indicator. It was designed to help traders identify trending markets and determine trend strength but not the direction of the trend. The indicator is based on comparing the highs and lows of price bars and does not use the close of the bar.
Backtesting results show that a short period of about 5-10 days works best, and the best threshold value for a strong trend is around 30-40, rather than the 25 popularly used.
What is the IBS indicator?
The Internal Bar Strength indicator (IBS) measures the relative position of the closing price relative to the High and Low. It is a mean-reversion indicator that helps you buy on weakness and sell on strength (mean reversion). The indicator oscillates between 0 and 1. As a mean-reversion indicator, a low value is a bullish signal, while a high value is a bearish signal.
The backtesting result of a simple IBS strategy where the asset is bought on price close if IBS is lower than 0.2 and sold any day later when the IBS closes above 0.8 showed reasonable performance, with a profit factor of 1.92.
How do you use RSI and ADX together?
See below trading strategies combining them perfectly.
RSI, ADX trading strategy (backtest and example)
Let’s backtest all RSI, IBS & ADX indicators with specific trading rules and settings. We start with IBS.
RSI, ADX and IBS (Big Three strategy) and backtest 1: IBS indicator
We make the following trading rules and backtest on the Nasdaq 100 index. We use QQQ as a proxy for Nasdaq 100. The trading rules are like this:
- If the IBS is below 0.1, we buy QQQ at the close.
- We sell at the close when the IBS is above 0.9.
The equity curve looks like this (why the equity curve is important):
The average gain per trade is 0.78%, and the CAGR (how to calculate CAGR) is 12.1% while only being invested 38% of the time, thus having a risk-adjusted return of almost 32% (what is risk-adjusted return?). We believe these numbers are pretty spectacular for such a simple strategy!
RSI & ADX strategy and backtest 2: The RSI Indicator
Let’s backtest the second of theRSI & ADX indicators: the RSI indicator, perhaps the most famous trading indicator.
We make the following trading rules and backtest by using S&P 500 (SPY):
- When the 2-day RSI is below 10, we go long at the close.
- When the 2-day RSI is above 90, we sell at the close.
The equity curve of the strategy looks like this:
The average gain per trade is 0.98%, and the CAGR is 7.5% while only being invested 41% of the time, thus having a risk-adjusted return of almost 18%. Again, we believe these numbers are pretty good for such a simple strategy!
Big Three strategy and backtest 3: The ADX Indicator
The last of our RSI & ADX is the ADX indicator. We backtest the ADX indicator with the following trading rules (S&P 500 – SPY):
- When the 100-day ADX is above 7, we are long S&P 500.
- When the 100-day ADX is below 7, we are out of the market.
The equity curve looks like this:
There are 28 trades, and the CAGR is 6.5%. The time spent in the market is 63%, and this strategy has a risk-adjusted return more like the buy and hold: 10.3%.
The ADX indicator might not look very good. However, the ADX indicator adds much value when used with other trading indicators.
Combining all or some of the RSI & ADX & IBS indicators
Let’s end this article by making a backtest where we combine two of the Big Three indicators (S&P 500 – SPY).
There are 270 trades, and the average gain per trade is 0.86%. Worth noting is that you are invested only 14% of the time, and hence the risk-adjusted return is 56%! Even in 2022, when the market is down, the strategy has made profits, just like in 2008. The only losing year is 2018, with a negative 5.5%.
It works even better in QQQ:
In QQQ, the average gain per trade is 1.3%, with no losing years since 2000.
There are two variables for the buy signal and one for the sell signal. Would you like to know the logic or the code for the strategy? We published the strategy in October 2020, and it has (so far) good out-of-sample performance. However, as always, there are no certainties in trading.
Order by clicking here (check for strategy no.4):
RSI & ADX Trading Strategy — ending remarks
Most trading indicators and strategies require two or more variables. However, we stress the importance of keeping trading simple:
- Simple Vs Complex Trading Strategies: The Simpler The Better
- 2 Reasons Why Less Is More In Trading (Keep Trading And Investing Simple)
Can the strategy be improved?
We are not oracles, and we are pretty sure there are traders out there who can improve the strategy. Do you have any ideas on how to improve it?
If so, please comment below or drop us an e-mail.