Myth Busting – RSI Indicator

Hopefully if you have been reading our material for a while you will have noticed how much we mention about risk and reward and probabilities in order to get your trading right.

For those who haven’t the key summary is as follows:

  • You can be profitable even if you win only a small percentage of the time (i.e 30%) as long as you have really good risk management
  • The key to trading is consistency and ensuring you can accurately work out the probability of your strategy so that you can apply sound risk management

We really do suggest you brush up on this, as it is fundamental to making money in trading. No-one cares if you are right, win rates are irrelevant beyond working out risk reward as its all about returns (money).

And this is where Metastock has a fantastic tool in its forecaster, which frankly has never been available to Retail Traders until now, but it’s something we use a lot of in the quant world.

So a forecaster looks back over a large amount of data, applies your trading rules and tracks what happens to price after the strategy or trading signal triggers. It then collates all this information and gives you probabilities associated to what might occur.

What I am going to show you today is the old RSI Indicator and the ever popular Oversold and Overbought strategy and their probabilities on daily timeframes using default periods.

The strategy we will test is whether on a 14 Period RSI we will take a long trade (buy) if we get an Oversold signal, and a short trade (sell) if we get an Overbought signal.

So this is what the chart looks like after the analysis,

EURUSD RSI Oversold

Pretty eh – but what is this telling us?

So on a daily chart this is highlighting what happens after an RSI Oversold signal occurs using the typical 14 day period.

With this we get a nice report of which I will pull out key highlights below:

  • Statistically, 7 days after the event occurs and with a probability of 95%, the closing price appears to be about 0.23% lower with a standard deviation of 0.0113.
  • Statistically, 14 days after the event occurs and with a probability of 95%, the closing price appears to be about 0.16% lower with a standard deviation of 0.0187.
  • Statistically, 30 days after the event occurs and with a probability of 95%, the closing price appears to be about 0.70% higher with a standard deviation of 0.0248.

So on EURUSD, looking back over the full price history of the currency pair, when we see an RSI Oversold signal, chances are that price will stay at current levels or lower for the next 14 days and it’s not until 30 days after the event that there is a higher probability of the price actually moving higher.

Now obviously the numbers are far more detailed and have margins for errors, but actually this shows that a 14 period RSI is by all means a pretty poor indicator of future price movements on EURUSD

How about on other currency pairs?

Lets take USDJPY and look at Overbought signals this time.

USDJPY RSI Overbought

So instantly it’s not looking good, by the heat map alone we can see that the highest probability (the deeper red) is pointing to higher prices in the short term on an RSI 14 period Overbought signal.

In fact when we look at the details

  • Statistically, 7 days after the event occurs and with a probability of 95%, the closing price appears to be about 0.48% higher with a standard deviation of 0.0135.
  • Statistically, 14 days after the event occurs and with a probability of 95%, the closing price appears to be about 0.53% higher with a standard deviation of 0.0243.
  • Statistically, 30 days after the event occurs and with a probability of 95%, the closing price appears to be about 2.92% higher with a standard deviation of 0.0352.

Actually maybe we should consider this as a good signal for going long, not short?

Ok, let’s take one more but it’s starting to look like the 14 period RSI Overbought for a sell signal and Oversold for a buy signal is a pretty rubbish strategy that you would need enormous risk reward potential on to take a trade.

AUDUSD

This time let’s test the Oversold system again. The idea being we ought to buy on Oversold.

AUDUSD RSI Oversold

Instantly by the chart we can see this won’t work in our favour and looking at the stats it is clear.

  • Statistically, 7 days after the event occurs and with a probability of 95%, the closing price appears to be about 0.06% lower with a standard deviation of 0.0259.
  • Statistically, 14 days after the event occurs and with a probability of 95%, the closing price appears to be about 0.24% higher with a standard deviation of 0.0292.
  • Statistically, 30 days after the event occurs and with a probability of 95%, the closing price appears to be about 1.18% higher with a standard deviation of 0.0441.

So our initial strategy would only work with really high risk reward targets. In fact a much better strategy might be to Sell on Oversold and Buy on Overbought…

Any questions about this for Sam? Tweet him at @LFXSam or email us here

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