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System concept: The Relative Strength Index (RSI) is a momentum indicator that oscillates between zero and 100, where values above a certain level (default 70) indicate overbought situations and values below 30 indicate the opposite. The indicators default lookback period is 14. (See Key Concepts and Definitions, p. 81, for more information on the RSI.) Typically, the indicators overbought and oversold levels are fixed. Standard RSI systems usually issue buy signals when the RSI exits the oversold area (i.e., crosses above 30) and give sell signals as soon as the RSI leaves the overbought area (i.e., drops below 70). This system experiments with changing the overbought/oversold levels depending on market condiSource for all figures: Wealth-Lab Inc. (www.wealth-lab.com) tions. For example, during low-volatility periods it is usually better to set the boundaries at, FIGURE 2 EQUITY CURVE say, 60 and 40, because the indicator is less likely to The system was profitable overall, but it did have one substantial fluctuate extremely higher or lower during such peridrawdown period. ods. Conversely, very volatile periods might require levels of 80 and 20 to avoid generating too many false signals. This system changes the RSIs oversold/overbought boundaries dynamically. (As the testing will illustrate, doing this converts a losing system into a profitable one.) To accomplish this, the system applies Bollinger Bands (see Key Concepts and Definitions, p. 81) to the RSI itself. As a result, instead of using fixed overbought and oversold levels, these readings are defined by the dynamic Bollinger Band calculation as the bands change according to the RSIs volatility, so do the overbought/oversold levels. Rules: 1. Go long next day at market if the 14-day RSI crosses above the lower Bollinger Band, using a 100-day simple moving average and two standard deviations for the Bollinger Band parameters. 2. Exit long next day and go short at market if the 14-day RSI crosses below its upper Bollinger Band. 3. Place a stop-loss four times the 10-day average true range (ATR) from the entry price. Figure 1, which shows trades in the S&P 500 E-Mini futures (ES), illustrates how the RSI bands adapt to changing volatility. In August 2003, the lower band was at 44 and the higher band was at 74. On Aug. 8 the RSI crossed above its lower band, issuing a buy signal; a standard RSI system with a fixed oversold level of 30 or 40 would not have caught this trade opportunity. The system stayed in this trade until Jan. 12, when the RSI crossed below the upper band and the system went
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short. It exited when a second crossover above the lower band occurred on March 18. Money management: Risk a maximum of two percent of account equity per trade. The number of contracts is calculated using the basis price (the closing price of the entry bar), the stop-loss level, and the dollar value of a one-point move in a particular contract.
www.activetradermag.com November 2005 ACTIVE TRADER
Other than the 2002-2003 drawdown, the system suffered mostly minor setbacks.
FIGURE 4 ANNUAL PERFORMANCE Three of the 10 years in the test period were losers; six of the seven profitable years had annualized profits of more than 10 percent.
STRATEGY SUMMARY
Profitability Trade statistics Net profit ($): 1,003,130.88 No. trades: 493 Net profit (%): 100.31 Win/loss (%): 52.54 Exposure (%): 18.42 Avg. trade (%): 1.50 Profit factor: 1.18 Avg. winner (%): 10.87 Payoff ratio: 1.25 Avg. loser (%): 8.71 Recovery factor: 1.40 Avg. hold time (days): 79.01 Drawdown Avg. hold time (winners, in days):101.78 Max. DD (%): -40.79 Avg. hold time (losers, in days): 53.80 Longest flat days: 462 Max. consec. win/loss: 10/9
LEGEND: Net profit Profit at end of test period, less commission Exposure The area of the equity curve exposed to long or short positions, as opposed to cash Profit factor Gross profit divided by gross loss Payoff ratio Average profit of winning trades divided by average loss of losing trades Recovery factor Net profit divided by max. drawdown Max. DD (%) Largest percentage decline in equity Longest flat days Longest period, in days, the system is between two equity highs No. trades Number of trades generated by the system Win/Loss (%) The percentage of trades that were profitable Avg. trade The average profit/loss for all trades Avg. winner The average profit for winning trades Avg. loser The average loss for losing trades Avg. hold time The average holding period for all trades Avg. hold time (winners) The average holding time for winning trades Avg. hold time (losers) The average holding time for losing trades Max. consec. win/loss The maximum number of consecutive winning and losing trades www.activetradermag.com November 2005 ACTIVE TRADER
PERIODIC RETURNS
Avg. Sharpe Best Worst Percentage Max. Max. return ratio return return profitable consec. consec. periods profitable unprofitable Weekly Monthly Quarterly Annually
11 11 8 4
14 6 3 1
LEGEND: Avg. return The average percentage for the period Sharpe ratio Average return divided by standard deviation of returns (annualized) Best return Best return for the period Worst return Worst return for the period Percentage profitable periods The percentage of periods that were profitable Max. consec. profitable The largest number of consecutive profitable periods Max. consec. unprofitable The largest number of consecutive unprofitable periods Trading System Lab strategies are tested on a portfolio basis (unless otherwise noted) using Wealth-Lab Inc.s testing platform. If you have a system youd like to see tested, please send the trading and money-management rules to editorial@activetradermag.com.
Disclaimer: The Trading System Lab is intended for educational purposes only to provide a perspective on different market concepts. It is not meant to recommend or promote any trading system or approach. Traders are advised to do their own research and testing to determine the validity of a trading idea. Past performance does not guarantee future results; historical testing may not reflect a systems behavior in real-time trading.
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FUTURES
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Using standard, fixed RSI overbought and oversold levels produced terrible results. Every year was a loser, and the system destroyed 65 percent of its initial equity.