Dr. Bruce Vanstone

Indicators – what are you measuring?

Example: RSI

Bruce Vanstone 2

This material is presented for educational purposes only.

I am not a financial advisor, and this material is not advice.

In many cases, the material represents ongoing research findings.

Disclaimer

Dr. Bruce Vanstone

Relative Strength Indicator◦ Welles Wilder (New Concepts in Technical Trading

Systems,1978)

One of the worlds most used indicators◦ Or perhaps, one of the worlds worst used indicators!

What's important for this discussion is its calculation

RSI

Dr. Bruce Vanstone

Classic interpretation is buying oversold readings, and selling overbought readings

Often these are set as oversold at 30 and overbought at 70◦ Of course, there are many ways to use RSI, but

we can use these levels as a basic demo of the problem and solution

Interestingly, it is normally considered a leading or coincidental indicator

Typical Interpretation

Dr. Bruce Vanstone

RSI = 100 - ( 100 / ( 1 + RS ) )

where◦ RSI relative strength index

RS = (average of n bars' up closes) / (average of n bars' down closes)n = number of bars or period

Note in calculating the RS values for the total of closes up, add all price changes where the close is greater then previous close. For closes down, add all price changes where the close is less then previous close.

Finally, the RSI formula may be found in some technical references as the following equivalent expression:

RSI = 100 * UpDaysAvg / ( UpDaysAvg + DownDaysAvg )

RSI – the calculation

Dr. Bruce Vanstone

Something of interest here mathematically is the cumulative addition of price changes

As traders (and academics), we accept that a lot of the movement of a stock prices is somehow related to the market◦ For traders, its that an up day on the market

usually means stocks in general trended up◦ For academics, it is beta

RSI - issues

Dr. Bruce Vanstone

The implication is that a lot of the “numeric value” (and hence meaning) of the indicator is probably not actually related to your stock!◦ It is related to the market as a whole

That should help explain why sometimes an indicator seems ‘spot on’ and sometimes it ‘misses by a mile’

In reality, there are a lot of other things wrong with indicators! Its also why most long-term successful traders use only 1 or 2, and often, none!

RSI - issues

Dr. Bruce Vanstone

If ◦ a lot of the indicator value is probably not actually

related to your stock, and ◦ a lot of the movement of a stock prices is somehow

related to the market, then we can use this to enhance the indicator

By simply detrending the indicator◦ And that’s easy, just subtract a moving average from

it… the larger the moving average, the greater the detrending period The moving average could be of the market, but just

using the same stock is almost as good (as most of its movement is probably also market related)

RSI - issues

Dr. Bruce Vanstone

Two identical systems

A – uses normal RSI calculation (14 days)◦ Buy when indicator less than 30, sell when indicator

greater than 70

B - uses detrended RSI calculation (14 days)◦ Buy when indicator less than 30, sell when indicator

greater than 70

REMEMBER THE DNA IDEA, DON’T FOCUS ON WHETHER YOU LIKE THE RULES OR NOT, THAT’S NOT IMPORTANT

Simulation

Dr. Bruce Vanstone

All ASX200 index members, $100,000, 5% equity position sizing◦ Includes transaction costs, historical data,

delisted companies, index adjustments, name changes

Simulation

Dr. Bruce Vanstone

Equity Curves

Dr. Bruce Vanstone

Monte-Carlo simulations

Dr. Bruce Vanstone

Although RSI was used as an example, this kind of idea can be applied and tested on any indicator particularly if it is built through successive, continuous computation

A further point from earlier:◦ Even though the RSI indicator has been

substantially improved using this technique, just like most indicators, it has virtually no inherent value at all Remember that indicators are supposed to be used

to confirm price action, not to replace it

Summary