Market: Futures.

System concept: The Relative StrengthIndex (RSI) is a momentum indicatorthat oscillates between zero and 100,where values above a certain level(default 70) indicate overbought situa-tions and values below 30 indicate theopposite. The indicator’s default look-back period is 14. (See “Key Conceptsand Definitions,” p. 81, for more infor-mation on the RSI.)

Typically, the indicator’s overboughtand oversold levels are fixed. StandardRSI systems usually issue buy signalswhen the RSI exits the oversold area(i.e., crosses above 30) and give sell sig-nals as soon as the RSI leaves the over-bought area (i.e., drops below 70).

This system experiments withchanging the overbought/oversoldlevels depending on market condi-tions. For example, during low-volatil-ity periods it is usually better to set the boundaries at,say, 60 and 40, because the indicator is less likely tofluctuate extremely higher or lower during such peri-ods. Conversely, very volatile periods might requirelevels of 80 and 20 to avoid generating too many falsesignals.

This system changes the RSI’s oversold/over-bought boundaries dynamically. (As the testing willillustrate, doing this converts a losing system into aprofitable one.) To accomplish this, the system appliesBollinger Bands (see “Key Concepts and Definitions,”p. 81) to the RSI itself. As a result, instead of usingfixed overbought and oversold levels, these readingsare defined by the dynamic Bollinger Band calcula-tion — as the bands change according to the RSI’svolatility, so do the overbought/oversold levels.

Rules:1. Go long next day at market if the 14-day RSI

crosses above the lower Bollinger Band, using a 100-day simple moving average and two standard deviations for the Bollinger Band parameters.

2. Exit long next day and go short at market if the 14-day RSI crosses below its upper Bollinger Band.

3. Place a stop-loss four times the 10-day average true range (ATR) from the entry price.

Figure 1, which shows trades in the S&P 500 E-Minifutures (ES), illustrates how the RSI bands adapt to changingvolatility. In August 2003, the lower band was at 44 and the high-er band was at 74. On Aug. 8 the RSI crossed above its lowerband, issuing a buy signal; a standard RSI system with a fixedoversold level of 30 or 40 would not have caught this tradeopportunity. The system stayed in this trade until Jan. 12, whenthe RSI crossed below the upper band and the system went

short. It exited when a second crossover above the lower bandoccurred on March 18.

Money management: Risk a maximum of two percent of accountequity per trade. The number of contracts is calculated using the“basis price” (the closing price of the entry bar), the stop-losslevel, and the dollar value of a one-point move in a particularcontract.

68 www.activetradermag.com • November 2005 • ACTIVE TRADER

FIGURE 2 EQUITY CURVE

The system was profitable overall, but it did have one substantialdrawdown period.

Trading System LabTrading System LabFUTURES

FIGURE 1 TRADE EXAMPLE

Applying Bollinger Bands to the RSI creates dynamic overbought and oversold lev-els that caught two good trading opportunities in the S&P 500 E-Mini futures.

Source for all figures: Wealth-Lab Inc. (www.wealth-lab.com)

Adaptive RSIsystem for futures

Disclaimer: The Trading System Lab is intended for educational purposes only toprovide a perspective on different market concepts. It is not meant to recommendor promote any trading system or approach. Traders are advised to do their ownresearch and testing to determine the validity of a trading idea. Past performancedoes not guarantee future results; historical testing may not reflect a system’sbehavior in real-time trading.

Profitability Trade statisticsNet profit ($): 1,003,130.88 No. trades: 493Net profit (%): 100.31 Win/loss (%): 52.54Exposure (%): 18.42 Avg. trade (%): 1.50Profit factor: 1.18 Avg. winner (%): 10.87Payoff ratio: 1.25 Avg. loser (%): 8.71Recovery factor: 1.40 Avg. hold time (days): 79.01Drawdown Avg. hold time (winners, in days):101.78Max. DD (%): -40.79 Avg. hold time (losers, in days): 53.80Longest flat days: 462 Max. consec. win/loss: 10/9

STRATEGY SUMMARY

LEGEND: Net profit — Profit at end of test period, less commission •Exposure — The area of the equity curve exposed to long or short positions,as opposed to cash • Profit factor — Gross profit divided by gross loss •Payoff ratio — Average profit of winning trades divided by average loss of los-ing trades • Recovery factor — Net profit divided by max. drawdown •Max. DD (%) — Largest percentage decline in equity • Longest flat days —Longest period, in days, the system is between two equity highs • No. trades— Number of trades generated by the system • Win/Loss (%) — The per-centage of trades that were profitable • Avg. trade — The average profit/lossfor all trades • Avg. winner — The average profit for winning trades • Avg.loser — The average loss for losing trades • Avg. hold time — The averageholding period for all trades • Avg. hold time (winners) — The averageholding time for winning trades • Avg. hold time (losers) — The averageholding time for losing trades • Max. consec. win/loss — The maximumnumber of consecutive winning and losing trades

LEGEND: Avg. return — The average percentage for the period • Sharperatio — Average return divided by standard deviation of returns (annualized)• Best return — Best return for the period • Worst return — Worst returnfor the period • Percentage profitable periods — The percentage of periodsthat were profitable • Max. consec. profitable — The largest number of con-secutive profitable periods • Max. consec. unprofitable — The largest num-ber of consecutive unprofitable periods

Trading System Lab strategies are tested on a portfolio basis (unlessotherwise noted) using Wealth-Lab Inc.’s testing platform.

If you have a system you’d like to see tested, please send the trad-ing and money-management rules to editorial@activetradermag.com.

For example, if a contract has a point value of$250, assume the system goes long at $100 (the basisprice) with an initial stop-loss at $90. To determinethe trade’s dollar risk, multiply the point value($250) by the difference between the basis price andthe risk-stop; in this case $250*$10 = $2,500. If theportfolio’s equity at the time of the trade is$1,000,000, because we are risking two percent ofour total equity (or $20,000), we would buy eightcontracts.

Had total equity been less than $125,000, wewould not have been able to take this positionbecause its dollar risk would exceed the system’stwo-percent equity risk. This position-sizing methodavoids risky trades with the potential to wipe outthe account.

Starting equity: $1,000,000. Deduct $20 commissionper round-trip trade per contract. Apply two ticks ofslippage per order.

Test data: The system was tested on the Active TraderStandard Futures Portfolio, which contains the fol-lowing 20 futures: British pound (BN), soybean oil(BO), corn (C), crude oil (CL), cotton (CT), Nasdaq100 E-Mini (NQ), S&P 500 E-Mini (ES), five-year T-note (FV), Euro Forex (EC), gold (GC), Japanese yen(JY), coffee (KC), wheat (W), live cattle (LC), leanhogs (LH), natural gas (NG), sugar (SB), silver (SI),Swiss franc (SF), and 30-year T-bonds (US). The testused ratio-adjusted data from Pinnacle Data Corp.

Test period: January 1995 until January 2005.

Test results: The portfolio equity curve (Figure 2) shows two niceperiods during which equity increases steadily and drawdownsare minor. However, between these periods (from January 2002until January 2003) a large 40.8-percent drawdown occurs.

Because of this drawdown, the overall performance is “only” 100percent after 10 years.

The drawdown curve in Figure 3 shows how dramatic thecontinued on p. 70

www.activetradermag.com • November 2005 • ACTIVE TRADER 69

PERIODIC RETURNS

Avg. Sharpe Best Worst Percentage Max. Max.return ratio return return profitable consec. consec.

periods profitable unprofitableWeekly 0.16% 0.52 7.61% -7.64% 50.57 11 14Monthly 0.70% 0.50 12.20%-13.25% 60.00 11 6Quarterly 2.09% 0.51 17.05%-23.15% 60.00 8 3Annually 9.21% 0.42 49.61%-28.01% 70.00 4 1

FIGURE 3 DRAWDOWN CURVE

Other than the 2002-2003 drawdown, the system suffered mostly minorsetbacks.

FIGURE 4 ANNUAL PERFORMANCE

Three of the 10 years in the test period were losers; six of the sevenprofitable years had annualized profits of more than 10 percent.

FUTURES continued from p. 69Trading System LabTrading System Lab

drawdown peak is at the beginning of 2003. However, therest of the test period contains relatively small draw-downs, from which the system recovers quickly.

Seven of 10 years in the test period are profitable(Figure 4, p. 69) and six show annual profits of morethan 10 percent.

The system’s relatively low average profit/loss of 1.50percent makes this system vulnerable to both highercommission costs and slippage. The system’s exposure(18.4 percent) is not too high; perhaps it’s worth consid-ering increasing the position size to improve profits.However, this is a double-edged sword as risk anddrawdown will increase, too.

To get an idea if the dynamic overbought-oversoldlevels provided by Bollinger Bands improved the RSI’sperformance, we also tested the system using fixed lev-els of 30 and 70 (all other parameters and rules were thesame). Figure 5 shows this system’s equity curve: It wasa consistent loser over the entire 10-year test period.

Bottom line: Replacing fixed RSI overbought and over-sold levels with adaptive levels converted a losing indi-cator/system into a profitable one. The adaptive sys-tem’s relative success highlights the potential benefits ofincorporating ideas that respond to changing marketconditions, including volatility fluctuations.

-José Cruset of Wealth-Lab

FIGURE 5 EQUITY CURVE — STANDARD RSI SYSTEM

Using standard, fixed RSI overbought and oversold levels producedterrible results. Every year was a loser, and the system destroyed65 percent of its initial equity.