The RSI is one of the most popular indicators used in technical analysis. However, most people use it as a mean reversion indicator rather than a momentum indicator. Today, we show you an RSI range-momentum trading strategy.
The RSI range-momentum trading strategy uses the RSI as a momentum indicator for identifying uptrends in stocks and ETFs.
This article will look at the RSI and how to use it for momentum trading and backtesting a trading strategy.
What is the RSI indicator?
The relative strength index (RSI) is a momentum indicator used in technical analysis developed by J. Welles Wilder Jr. and introduced in his book New Concepts in Technical Trading Systems in 1978.
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The RSI measures the speed and change of price movements. The indicator is plotted on a scale of 0 to 100, with overbought conditions generally occurring above 70 and oversold conditions occurring below 30.
It is calculated using a formula that considers an asset’s average gain and loss over a specified period, typically 14 days. We won’t go into details about the calculation, but rather focus on backtesting the strategy.
How to use the RSI for momentum
Traders are used to implementing RSI for mean reversion strategies. For example, one of the most known strategies is to sell an asset when the RSI is above 70 and buy it when it crosses below 30.
However, the true nature of the RSI is to be a momentum indicator. As the RSI formula shows, RSI readings above 50 mean that the average gain is greater than the average loss. In other words, prices are generally rising when RSI remains above 50 and generally falling when RSI remains below 50.
Practitioners have noticed that RSI typically ranges from 40 to 80 during an uptrend and 20 to 60 during a downtrend. During a normal pullback, RSI finds support and reverses in the 40-50 zone. A move to 30 suggests something more than just a pullback.
As we are about to see in this article, this is the backbone of the RSI range-momentum trading strategy that we will backtest today.
RSI range-momentum trading strategy – trading rules
This strategy is inspired by a paper called Finding consistent trends with strong momentum by Arthur Hill.
The strategy consists of two indicators:
- RSI bull range: RSI fluctuates between 40 and 100 over N days.
- RSI bull momentum: highest high value of RSI is greater than 70 over N days.
For this backtest, we will use the 100 days lookback period and the 14-day RSI. This means that, for example, for the RSI bull range to flash a signal, the RSI must have fluctuated between 40 and 100 over the last 100 days.
Having this in mind, the strategy is pretty simple:
- Buy the SPY when the RSI bull range and bull momentum are true.
- Sell the SPY when the RSI bull range and bull momentum are false.
In case there are any doubts, here is an example from the paper:
The buy signal is triggered when both the RSI bull momentum and RSI bull range are true. The sell signal only happens when both indicators turn false. If, after the buy signal is triggered, one indicator turns false but the other stays true, we wouldn’t exit the position.
RSI range-momentum trading strategy – backtest
We backtested the strategy on S&P 500 (by using the ETF with ticker code SPY) going back to 1993. The data is adjusted for dividends.
Here is the equity curve:
The strategy metrics and statistics can be broken down into the following numbers:
- CAGR is 5.93% (buy and hold 9.58%)
- Time spent in the market is 35.7%
- Total trades are 12
- The win ratio is 83%
- The average win per trade is 17.5%
- Maximum drawdown is 12.9%
- Risk-adjusted return: 16.61% (CAGR divided by time spent in the market (0.357))
For being invested only 35% of the time, the strategy performs well.
As we can see, the strategy does not generate a ton of signals, but the ones it does trigger are very profitable. Out of the 12 signals, only 2 lost money, but more importantly, the maximum drawdown is modest, thus protecting the portfolio from large losses.
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RSI range-momentum trading strategy – conclusion
To sum up, the RSI range-momentum trading strategy has proven to generate good returns for S&P 500. Although it may not produce many signals, it helps identify momentum periods and bull markets.