Option Samurai’s option scanner is designed to help you find the best options trades while compiling many different data sources. The goal is to help you utilize different edges in your trades, thus making your trading more robust. To do that, we often backtest specific data points and trades to help you maximize your advantage. We have a series about the Implied Volatility edge and backtest, and you can read the first part here.
This will be the first of a series of backtests to test different technical indicators to help you get the maximum out of our technical analysis engine.
In this part, we will use our table backtest framework and the RSI indicator.
What is the RSI indicator?
The Relative Strength Index is one of the most common technical indicators. It is designed to compare the current strength of the asset compared to its past value. Read more about it in our Knowledgebase. We will use it as a contrarian indicator for mean-reverting trades, meaning that when it is extremely low, we will go long, and when it is extremely high, we will go short.
What is the table backtest framework?
The table backtest framework is a backtesting framework we invented that tests the average change in an asset after an event. The table backtest is designed to show you variations of this event and their effect on the change at a glance. Here is an example:
The rows on the right show us the different threshold for the events: Above 90, Above 80, Above 70, etc.
The columns show us what was the average change X days later: 5 days (1 week), 10 days (2 weeks), 15 days (3 weeks), and 20 days (about a month).
The cells themselves show us the average change of the asset OVER the regular shift. This means that if we see 1%, it means that in that scenario, the asset moves 1% MORE than usual on average.
For example, in this table, we see that the SPY moved on average 2.99% MORE than usual after the RSI breached 20. Also, after the RSI crossed 80, it changed on average -3.75% LESS than usual in 20 days.
The power of this backtest is that it shows us different thresholds and events and how they affect the change of what we are testing in one glance.
Before we check the backtest results – it is important to remember that technical analysis is trying to understand the supply and demand of assets VIA price action, indicators, etc. This is why it is essential to understand the market mechanic. For example, if we are in a bull market, arrows will behave a certain way, and if we are in a panic – they will behave differently. We will dive more into it in the following analysis.
RSI on indexes
The following tables so the change of the underlying ETF after the 14-days-RSI reached the threshold on the left column. The data is from 2015 until October 2020, including the COVID crush:
If you remember the IV backtest we ran, you see that the results here are not ‘clear cut’ as they were in the IV case. However, we can see essential and clear insights from these backtests:
- Extreme – Usually, oversold and overbought thresholds in RSI are set to 30 and 70. In the case of RSI, we want to have more extreme thresholds (IE 20/80). This is the clearest in IWM, where under 30 is still bearish, but under 20 is starting to be bullish (barely).
- Trend following: Although an extreme reading shows a revision to mean in the following week, We see a tendency to continue with the trend later. For example, if we look at the SPY and values under 20. We can see that we can expect a 3% up move in the following week, but only a 1.5% up move in 2 weeks, so week two was negative. In the next three weeks, we have an average negative move, which means that the two weeks after the first positive week.
Before describing more insights, I want to show the backtest results if we exclude 2020. The following results are from 2015 until Dec 2019 – Without 2020:
Let’s focus on SPY to see the differences: If we exclude the 2020 results, we can see that the indicator provides us with a much better signal. For example:
- When the RSI is under 20, we can expect the market to revert – 3.68% on average on the first week, up to 5.43% three weeks after the signal.
- Similarly, if we are above 80, we can expect a short trend following in the next week, but it will revert to the mean in the weeks after that.
The difference is that during March of 2020, we saw the market crush about 30% due to the COVID pandemic. This put the markets in bearish territory for the first time since the financial meltdown of 2008/2009. The market mechanics operate differently during a bear market and bull markets, so it is essential to have a view of the market when you are using technical analysis.
I believe that if you have a bullish outlook on the market, you can use the results that exclude the 2020 meltdown, but if you are not sure or bearish – you want to use the results that include 2020.
How to use it in trading
Enter new positions – You can use the RSI indicator (and technical analysis) to enter new positions (with supporting signals). For example, if you are bullish, you can enter trades where RSI is below 20/30.
Delay entering new positions – if RSI is high (above 70), it is usually better to wait and not enter a new position.
Find trades – You can use the RSI filter to find trades to invest. If you are bullish, you can set the threshold to below 20 or 30 and even set a delay of a day or two to see if it continues lower.
If you are bearish, you can set it to 80 and time delay to ensure you have a higher probability of reverting back.
We have a predefined scan you can use (Sell OTM puts with a high probability of profit on stocks that are oversold), and we also sent a few trades from it in our Stocktwits account.
RSI is a technical indicator that can be used to enter mean-revision trades when it passes extreme thresholds. We saw that it is essential to have a view of the market before using it, as market mechanics affect the way it behaves.
When RSI is below 20, it is considered a bullish signal, and when RSI is above 80, it is regarded as a bearish signal. We can change the threshold to 30 and 70 if we want to be more aggressive and have confirming signals from other indicators.
In the coming articles, we will explore the technical indicators more in-depth, using different assets (such as commodities) and more trading frameworks.
- Technical analysis engine in our Knowledgebase
- Sell OTM puts on stocks that are oversold (in Option Samurai)
- More about the RSI indicator in our Knowledgebase
- The research we do into the Implied Volatility of options.