By Kristoff De Turck - reviewed by Aldwin Keppens
Last update: Apr 27, 2023
In this article I discuss a simple short-term strategy based on the RSI indicator. This is a mean reversion strategy, the theory behind this term states that extreme price movements always tend to return to their mean level. Some additional explanation can be found in this mean reversion article.
The method discussed here differs from another - also RSI2 based - strategy, developed by the American trader Larry Connors, in which overbought and oversold situations are identified to which the trader then tries to respond. The difference is that this strategy only reacts to the RSI2 signals in the direction of the existing long-term trend. As a result, it has characteristics more closely resembling a price retracement trend strategy.
Before there can be a mean reversion, of course, there must be a clear price extreme visible. You can do this purely by sight, looking at the price relative to an average price, say the SMA20. The chart below of Tilray Brands Inc (NASDAQ:TLRY) stock shows such a price extreme.
The Tilray Brands stock with an SMA20 illustrated on it. A sudden very sharp rise in price from March 23 with a peak price on March 27 indicates the upward price extreme (green arrow) where the price deviates far from the 20-day price average.
A similar price extreme but on the bearish side is seen in the stock of Biontech (NASDAQ:BNTX)
The Biontech stock with a sharply declining price leading to a downward price extreme where the price has deviated significantly from the SMA20.
The great advantage of a stock screener is that with a few smart price filters you can easily create a screen that looks for such price extremes fully automatically. Finding good setups is therefore not only much faster but also much more objective... This screen for example shows all stocks that are at their lowest point in the last 10 days and are at least 15% lower than the SMA20. The RSI(2) filter ensures that we only keep stocks whose RSI(2) value is lower than 20. This basic selection can then be used to further manually screen for the most interesting candidates.
Using the RSI(2) we try to identify the moment at which the recovery movement (regression to the mean) will possibly occur. We do so by looking for the moment on the chart when the RSI(2) indicates a value below 10 (bullish) or above 90 (bearish).
In the TLRY chart below we have added the RSI(2) indicator. You can see that its value exceeds 90 from 2022-02-24 indicating an extremely overbought situation. Also on date of 2022-02-25, the RSI is still quoting above the 90 level.
As for BNTX, we observe an RSI(2) below 10 from January 18, 2022 through January 21.
An upward or downward price extreme accompanied by an RSI(2) value quoting above 90 or below 10 are the two necessary conditions before this strategy can be applied.
This is the final step before we can configure the actual setup to enter the market. An RSI(2) with a value of +90 falling again below the 70 level is the indicator signal to go short.
In the chart of TLRY, the RSI(2) is recording just below 70 after the trading day of 2022-03-28.
An RSI(2) with a value below 10 which rises again above the 30 level is the indicator signal to go long. This can be observerd in the chart of BNTX on the date of 2022-01-25.
This setup to buy or sell is only possible if these first 3 steps are completed.
The use of a buy/sell stop limit order allows to determine the entry very precisely. With a 'Sell Stop Limit Order' we define that the price of the stock must first continue to fall below the low of the signal candle before the short order becomes active (in the case of TLRY).
In the case of BNTX a 'Buy Stop Limit order' is used where the price first has to rise above the high of the last candle before the order becomes active and can be executed.
For BNTX the order is triggered the very next trading day and barely 6 days later the price hits the SMA20 which is the first target. Depending on how you manage the position further the profit at this level can be cashed in partially or completely. For the remaining part the stoploss can be adjusted upwards.
As for TLRY, the price initially went a bit higher and the sell order was not triggered initially. The RSI(2) indicator thus again entered oversold territory at 2022-03-29. The following day, a bearish doji candle was formed and the RSI(2) falls below the 70-level for the second time.
A modified short entry just below the low of this doji candle with a stoploss above the high was definitely a setup to consider in the context of this mean reversion strategy. The position was never compromised in the process and the SMA20 was touched on date of 2022-04-07.