We all know there are no magic indicators but there is an indicator that certainly acted like magic over several decades. During 2011 the market experienced a sudden and sustained drop which put the system into loss. It has been slowly recovering since. Below is an equity graph depicting the trading system’s equity curve trading the SPX index from 1983. You can easily see the large drop around trade number 120.
Here is a closeup view of the last 19 trades, which covers about the last five years. The trading rules from Larry Connors are very simple and consist of long-only trades. Price must be above its 200-day moving average. Exit when price closes above the 5-day moving average.
Number of shares is normalized based on a 10-day ATR calculation. L of each trade is not reinvested. Is the 2-period RSI indicator losing its edge? Hard to say at this time. It’s not like drawdowns have not happened before, but that’s not really what I want to explore. I want to take a closer look at the 2-period RSI indicator and see if we can improve the basic trading system by Larry Connors.
In short, the 2-period RSI is designed to highlight strong pullbacks. Buying into pullbacks in an uptrend has been a well known and effective trading method and is the essence of the 2-period RSI trading system. We can demonstrate this by looking at how the market behaves after a trade is triggered. This shows that after our 2-period RSI indicator triggers a trade, the market tends to climb over the next 30 days. It’s also important to notice all values produce positive results.