- Speaker #0
Hello and welcome back to Papers with Backtest podcast. Today we dive into another algo trading research paper. This one really flips the script on a tool I bet most of us use for reversals, the RSI. You ready to see how it can actually power trend following and momentum strategies?
- Speaker #1
Yeah, the title of this paper got my attention too. Finding consistent trends with strong momentum RSI for trend following and momentum strategies. Most people think RSI is all about those overbought and oversold signals. But the author argues it's much more nuanced than that.
- Speaker #0
Okay, so for anyone who's just joining us or needs a super quick refresher, RSI stands for Relative Strength Index, right? It's that oscillator that bounces between 0 and 100. And we're usually taught to look for those extremes.
- Speaker #1
Yep, exactly. But here is where this paper throws us a curveball. It says that while those extremes can signal reversals, RSI is actually better at identifying strong, sustained trends.
- Speaker #0
So you're saying those times when RSI goes screaming above 70. Yeah. Which we normally think is overbought. Yeah. Those could actually be times to stay near the trade.
- Speaker #1
That's one of the big aha moments here. The author points out that those super high RSI readings are actually pretty rare. And when they DEO happen, it's often in stocks that are in powerful, long-lasting uptrends. Think of those mega growth companies that just keep climbing.
- Speaker #0
So instead of seeing RSI above 70 as a sell signal, we should be thinking, hmm, maybe this trend has legs.
- Speaker #1
Exactly. It's about shifting our perspective. The paper dives into specific RSI ranges that signal an uptrend 40 to 80 and a downtrend 20 to 60. Instead of single points, it's about how RSI behaves within these broader bands.
- Speaker #0
Interesting. So it's not just about hitting a certain number. It's about the overall pattern of RSI movement. I'm starting to see how this could work for trend following.
- Speaker #1
Now the paper gets really specific with its trading strategy. They use the S&P 500 stocks as their testing ground and look at a bunch of different look back periods. 25, 50, 75, 100. and 125 trading days for different RSI signals. They're trying to see if different time frames affect how well these signals work.
- Speaker #0
Got it. So they're essentially saying, let's see if using RSI over the past month, three months, six months, et cetera, gives us different results. Yeah. Kind of like zooming in or out on a chart.
- Speaker #1
Precisely. They analyze four main signals, bull range, where RSI is bouncing between 40 and 100, bear range, between zero and 60, bull momentum, when the highest RSI reading goes above 70, and and bear momentum where the lowest RSI dips below 30.
- Speaker #0
Okay, I'm already curious to see which of these signals actually worked. What did their backtesting reveal? Well,
- Speaker #1
the results are kind of like a treasure map. Some paths lead to gold, others lead to disappointment. The bull range signals, for example, had pretty low success rates, meaning they didn't lead to profits consistently. But T, when they did work, the profits were huge. They had really high profit-to-loss ratios.
- Speaker #0
Ah, so potentially a high-risk, high-reward kind of play. Big wins when you're maybe not consistent enough.
- Speaker #1
Right. And unsurprisingly, the bear range signals didn't fare well at all. Looks like trying to catch those downtrends with RSI wasn't a winning strategy in this study. Okay.
- Speaker #0
So far, it seems like focusing on the bullish signals was the way to go with this RSI approach. But those bull range signals, while tempting, were a bit unreliable, right?
- Speaker #1
Yes. And that's where the bull momentum signals come in. These actually had MSCH higher success rates. than the bull range signals, meaning they led to profits more consistently. The catch. Those profits weren't as big when they hit. Their profit to loss ratios were lower.
- Speaker #0
So it's that classic trader's dilemma. Consistency versus those home run trades. Did they find any way to combine the best of both worlds?
- Speaker #1
That's where it gets really interesting. The paper's secret sauce, their most intriguing finding, was combining the bull range and the bull momentum signals. They call this the bull range momentum signal.
- Speaker #0
Okay, let me make sure I've got this straight. So we're looking for RSI to stay above 40, indicating a strong consistent uptrend. And we want to see a burst above 70 at some point, showing that extra oomph of momentum.
- Speaker #1
You nailed it. And here's the kicker of this combo, especially when they use longer look back periods, significantly boosted the strategy's performance. It seems those longer term trends, when you get that confirmation of powerful momentum, are the real moneymakers.
- Speaker #0
I love how this is turning a traditional sell signal on its head. Instead of fearing RSI above 70, we're actually seeing it as a sign of potential strength.
- Speaker #1
Now to really grasp this, let's look at some specific examples from the paper. They actually show us how these signals played out in real-world scenarios.
- Speaker #0
Let's do it. Give me a stock where this full-range momentum signal really worked its magic.
- Speaker #1
They highlight Boeing. If you look at Boeing's stock chart from late 2016 to early 2018, it was on a tear. climbing steadily, and during that whole run, its RSI mostly hung out above 40, dipping below only briefly. Plus, it kept surging above 70, flashing those bull range momentum signals.
- Speaker #0
So this was a classic case of the trend is your friend, and this RSI approach was basically saying, hey, hop on board and ride this wave. What about a stock where the signals didn't work so well, just to see how we might avoid those pitfalls?
- Speaker #1
They point to Illumina. Their stock took a big hit in late 2018. And in the months leading up to that drop, their RSI had actually broken below 40. signaling that the uptrend might be ending.
- Speaker #0
Ah, so in this case, the RSI was like a canary in a coal mine, giving an early warning that things could go south.
- Speaker #1
Exactly. It highlights the fact that no trading strategy is foolproof. Even with robust signals like these, you're going to have times when things don't go as planned. But the key is to have a strategy where over time, the potential profits outweigh the potential losses. And this RSI-based trend-following approach thinks to offer that.
- Speaker #0
Okay, so we've seen how these signals play out in real life. But I'm thinking if everyone starts using this RSI strategy, won't it become a self-fulfilling prophecy? Like if everyone's buying when RSI hits 70, won't that push prices even higher, making the signal useless?
- Speaker #1
That's a really smart question. And it gets at the heart of how markets work. It's a bit of a chicken and egg situation. Do the signals create the trends or do the trends create the signals?
- Speaker #0
Right. Like, is it the RSI itself that's making the magic happen or is it just reflecting a trend that's already in motion?
- Speaker #1
It's probably a mix of. both. The signals can definitely help us spot existing trends. But if enough traders start piling in based on those signals, it can absolutely amplify the move, creating a feedback loop.
- Speaker #0
So it's not enough to just blindly follow the RSI. We need to understand the broader context, right? Like, is the overall market healthy? Are there other fundamental factors supporting the trend?
- Speaker #1
Absolutely. It's about combining this quantitative approach with good old-fashioned market awareness and due diligence. The RSI signals give us a framework. But we still need to think critically and make informed decisions.
- Speaker #0
It makes you realize that trading is as much an art as it is a science. You need the data, A&D, the intuition.
- Speaker #1
Well said. And speaking of data, the paper actually throws in an extra layer. The idea of adding a market timing mechanism to this RSI strategy, they think it could potentially boost performance even further.
- Speaker #0
Interesting. So it's like saying, even if a stock looks great based on its RSI, let's make sure the overall market is in our favor too.
- Speaker #1
Exactly. One way to do this is to use a simple moving average of a broad market index, like the S&P 500. Let's say we only take trades based on our RSI signals, IF. The S&P 500 is above its 200-day moving average.
- Speaker #0
Ah, so we're basically saying we only want to play this bullish RSI strategy when the broader market is also in an uptrend. It's like a double confirmation.
- Speaker #1
Right. It's all about tilting the odds in our favor, increasing our exposure to those favorable market conditions. and reducing our exposure when things look dicey.
- Speaker #0
That makes a lot of sense. But even with this added layer of market timing, it's not going to be perfect, right? Yeah. Markets can be unpredictable.
- Speaker #1
Of course. But the goal isn't to avoid losses entirely. It's to manage risk intelligently. This market timing element helps us do that.
- Speaker #0
Okay, so we've talked about the signals, the back testing, real world examples, even adding this market timing filter. But I'm curious, how would someone actually put this RSI strategy into practice? What are the steps involved?
- Speaker #1
Great question. First things first, you need a trading platform or charting software that lets you plot RSI and create custom indicators. Most decent platforms will have this functionality. Then you need to define the specifics of your strategy, your RSI levels for those bull and bear ranges, your look back periods, any other filters you want to use.
- Speaker #0
So it's about tailoring it to your personal trading style and risk tolerance.
- Speaker #1
Exactly. And of course, risk management is paramount. You have to set clear entry and exit points, stop loss levels, and position sizing rules. That's the bedrock of protecting your capital and staying in the game for the long haul.
- Speaker #0
Right, because even the best strategy can go wrong. So you need to be prepared for those inevitable bumps in the road.
- Speaker #1
Absolutely. Then once you've got your strategy clearly defined, the next step is backtesting it rigorously. Use historical data to see how it would have performed in different market conditions. It's like a dress rehearsal before the big performance.
- Speaker #0
Love that analogy. Backtesting is like... OK, let's see how this baby would have danced in the past before we take it out on the real dance floor.
- Speaker #1
Exactly. It helps you spot any weaknesses or areas for improvement and gives you an idea of the strategy's expectancy. Basically, the average profit or loss per trade. And if the backtesting results look good, then you can think about trading it live with real money.
- Speaker #0
But even then, it's not like you just set it and forget it, right? You've got to keep monitoring how the strategy performs. Yeah. Especially since markets are constantly evolving.
- Speaker #1
You got it. Trading is an ongoing journey of learning and adaptation. What works yesterday might not work tomorrow, so you have to stay nimble.
- Speaker #0
This whole conversation has really made me rethink how I use RSI. I've always been so focused on those overbought, oversold extremes, but now I'm seeing its potential for trend following.
- Speaker #1
It's a great reminder that even familiar tools can have hidden depths and that sometimes the most innovative strategies come from challenging conventional wisdom.
- Speaker #0
Well said. This paper has definitely given me a fresh perspective and some exciting new ideas to explore.
- Speaker #1
I'm glad to hear that. And I think that's one of the most important takeaways for our listeners to be open to new ideas, to experiment and to never stop learning.
- Speaker #0
Couldn't agree more. This is exactly why we do this podcast to share these insights and help traders expand their toolkit. Speaking of which. We've covered a lot of ground today.
- Speaker #1
Absolutely. We've unpacked this paper's key trading rules, dug into those fascinating backtest results, and even explored how to adapt the strategy to different market conditions.
- Speaker #0
And I think it's a great reminder that even seemingly complex strategies like this one, using RSI for trend following, can be broken down into logical, manageable steps.
- Speaker #1
And exactly. Once you grasp the... basic building blocks, indicators, backtesting risk management. It's like unlocking a whole new world of possibilities. You don't have to rely on someone else's black box system. You can start creating your own strategies.
- Speaker #0
That's so empowering. And I love that this paper encourages us to think differently, to challenge those traditional assumptions about how we use indicators like RSI.
- Speaker #1
It's a great example of how quantitative analysis can help us unearth hidden opportunities in the markets. But as we've discussed. it's not about blindly following signals. It's about understanding the why behind the strategy, being aware of its limitations and adapting it to the ever changing market landscape.
- Speaker #0
So as we wrap up, what's the one big takeaway you want our listeners to walk away with today?
- Speaker #1
I'd say it's this. Don't be afraid to experiment. Take the concepts we've discussed today and put them to the test. Play around with different RSI parameters, look back periods, filters, see what works best for you and your trading style.
- Speaker #0
Don't just take our word for it or the paper's word for it. Go out there and do your own research, your own backtesting. That's how you truly make a strategy your own.
- Speaker #1
Couldn't have said it better myself.
- Speaker #0
Well, on that note, it's time to wrap up this deep dive into the world of RSI trend following.
- Speaker #1
Thanks for joining us.
- Speaker #0
Thank you for tuning in to Papers with Backtest podcast. We hope today's episode gave you useful insights. Join us next time as we break down more research and for more papers and backtests, find us at https.paperswithbacktest.com. Happy trading.
- Speaker #1
Happy trading.
