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Stocks & Commodities V.

11:2 (57-60): Relative Momentum Index: Modifying Rsi by Roger Altman

Relative Momentum Index: Modifying RSI


by Roger Altman

Overbought/oversold indicators are popular among traders for identifying market turns. The relative strength index (R SI) is one such popular indicator. Here, Roger Altman presents his work on modifying the index to smooth the indicator's sensitivity to momentum and the benefits that result.

hen a technical indicator such as a moving average or stochastics fails to give a timely signal, it is

almost always due to the indicator's lookback period being out of phase with price movement. For most indicators to work properly, they need to use an accurate lookback value. Unfortunately, there is no correlation between the best lookback value from one period to another, and that is why most technical indicators are unreliable. But not all. J. Welles Wilder's relative strength index (R SI) has been one of the most popular overbought/oversold indicators since its publication in New Concepts in Technical Trading Systems in 1978. A notable attribute of the RSI is that its response to price fluctuations is insensitive to its sole parameter, the lookback period (value X shown in sidebar "The RSI and the RMI"). But the RSI is not always easy to interpret, because it doesn't oscillate evenly between overbought and oversold regions (Figure 1 gives an example for the Standard & Poor's 500). To compensate for this erratic behavior, technicians often use trendlines as well as support and resistance analysis of the RSI itself to help anticipate reversal points. These techniques have done little to improve the reliability of the relative strength index because chart analysis is more an art (that is, subjective) than it is a science (that is, objective) and, therefore, almost impossible to test statistically by computer.

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Stocks & Commodities V. 11:2 (57-60): Relative Momentum Index: Modifying Rsi by Roger Altman

FIGURE 1: The classic relative strength index using a 20-day lookback period. During the trading range in 1992, the RSI had different readings for overbought and oversold levels.

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Stocks & Commodities V. 11:2 (57-60): Relative Momentum Index: Modifying Rsi by Roger Altman

Unfortunately, there is no correlation between the best lookback value from one period to another, and that's why most indicators are unreliable. But not all.
So is there a way to retain the RSI's almost unique insensitivity to the lookback period while making its overbought/oversold oscillations appear more like a sinewave? The answer is yesif a second parameter is added to the RSI. RELATIVE MOMENTUM INDEX Thus, the RSI is modified by counting up and down days starting from today's close relative to the close Y days ago, where Y is not necessarily 1 as required by the RSI. The RSI is released from the arbitrary restriction of comparing consecutive days for price changes. Figure 2 shows the identical price history and lookback period (set at 20 days) given in Figure 1, but with Y set at 5 instead of 1. It is much easier to anticipate tradable reversal points compared with the one-parameter RSI. This modification is called the relative momentum index (RMI), in which momentum is substituted for strength, because a momentum index is usually obtained by creating a moving average of the most recent closing price compared with the close Y days in the past. RMI VS RSI To determine if the R MI is preferable to the RSI for predicting price reversal points, first divide the approximate 10-year database of Standard & Poor's 500 futures prices into four equal parts. Each of these four periods was used to search for the lookback period, overbought and oversold RSI reversal values that produced the largest percentage return on account, %ROA {net profit - after deducting slippage and commission divided by the sum of required margin and worst intraday drawdown} for momentum values (the variable Y in the sidebar), ranging from 1 through 9. Figure 3 gives the results of this test. Each momentum value has a performance range expressed as %ROA. The upper and lower end of the range correspond to the best and worst performance over the four periods studied. Crosses within each bar give the average of the four performance values . Note that the original RSI (with momentum parameter equal to 1) had the worst average performance compared with any of the other momentum parameters tested. However, the performance difference was not large enough to be statistically significant. As a consequence, a second test was run using the entire, undivided 10-year price history for each of the momentum parameters given earlier. The results are shown in Figure 4. Statistical analysis indicated that the RMI produced %ROA values that were significantly better than those generated by the RSI. Because this study was restricted to the S&P 500, no general conclusion can be drawn; interested readers should apply the tests described here on a variety of financial and commodity price histories to see if these results can be confirmed and, thus, interpreted generally. In any case, it is fair to say that the addition of the momentum parameter removes the arbitrary restriction of comparing only consecutive closing prices. A TRADING SYSTEM WITH RMI The RMI is a reversal indicator, so it should not be considered a stand-alone trading system because prices may break out of a trading range at any time, leaving the unsuspecting trader on the wrong side of the market and producing huge losses. At the very least, a money management protective stop should be included with the RMI before considering real-time trading.

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Stocks & Commodities V. 11:2 (57-60): Relative Momentum Index: Modifying Rsi by Roger Altman

FIGURE 2: the relative momentum index using a five-day momentum and a 20-day lookback period produced an indicator with more consistent peaks and troughs for overbought and oversold readings.

FIGURE 3: The 10-year database of S&P 500 futures prices was divided into four equal parts. Each of these four periods was used to search for the lookback period, overbought and oversold RSl reversal values that produced the largest % return on account {Net Profit - after deducting slippage and commission divided by the sum of required margin and worst intraday drawdown} for momentum values (variable Y in the sidebar) ranging from 1 through 9.

Stocks & Commodities V. 11:2 (57-60): Relative Momentum Index: Modifying Rsi by Roger Altman

FIGURE 4: A second test was run using the entire, undivided 10-year price history for each of the momentum parameters given earlier. Statistical analysis indicated that the RMI produced % ROA values that were significantly better than that generated by the RSI.

FIGURE 5: Using the RMI with established stock market seasonality patterns, sentiment and commercial activity from as well as chart-based support and resistance levels to trade futures on the NYFE, S&P 500 and OEX options produced this equity curve.

Stocks & Commodities V. 11:2 (57-60): Relative Momentum Index: Modifying Rsi by Roger Altman

I have been using the RMI with established stock market seasonality patterns, sentiment and commercial activity (using data from the Bullish Review) as well as chart-based support and resistance levels to trade futures on the New York Futures Exchange (N YSE), S&P 500 and OEX options since the beginning of 1992. Figure 5 is an equity curve for 27 real trades made between January and September 1992. Even though most of these trades have been successful, experience has taught me that in the long run this trading method requires more discipline than most traders can muster. The reason is simple. Although all these indicators are quantifiable, there is no practical way of establishing the importance of each to achieve a purely objective decision. Thus, when these indicators gave conflicting signals, I was forced to make a choice. Under most circumstances, this approach does not create problems, but if you treat trading as a businessthat is, you are willing to make a long-term commitment to become successful then this method is unsatisfactory because, inevitably, all trading systems exhibit extraordinarily large equity fluctuations. Novice traders don't realize how tempted they will be to alter their trading plans after encountering unusually large gains or losses. You should find the following scenario familiar if you have been trading for a while. A trader experiences a series of winning or losing trades, boosting or tempering his confidence. He begins to use greater leverage either because his sudden success gives him a feeling of invulnerability or, if he suffers large losses, he wants a quick fix to get back on track. An otherwise sound money management plan that produces normal equity variations is replaced with one that generates unacceptably large gyrations. At that stage, many traders begin to tinker with their systems, which usually exacerbates account volatility. Eventually, trading is suspended as the trader searches for a better approach. This process is repeated until account equity is depleted and/or the trader is completely demoralized. AVOIDING CALAMITY The only way to avoid calamity is to develop a purely mechanical trading method. A 100% mechanical trading system gives us a chance to become successful traders because past performance (whether hypothetical or real) can be compared statistically with current trading experience. By employing objective statistical tests, the trader can determine whether a current string of losing (or winning) trades is outside reasonable expectation. If it is, the trader should cease trading immediately but continue to paper trade all signals until either trading results become nominal again or the flaw responsible for the errant behavior has been detected and corrected. This type of evaluation can be done unemotionally and provides the best chance for long-term survival. Roger Altman is working on a purely mechanical system for the RMI.

FURTHER READING Altman, Roger [1990]. "Parameter optimization," Technical Analysis of STOCKS & COMMODITIES, Volume 8: December. Briese, Stephen E. [1990]. "Commitments of Traders as a sentiment indicator," Technical Analysis of STOCKS & COMMODITIES, Volume 8: May. Bullish Review, 14600 Blaine Avenue East, Rosemount, MN 55068,612-423-4949.

References

Copyright (c) Technical Analysis Inc.

Stocks & Commodities V. 11:2 (57-60): Relative Momentum Index: Modifying Rsi by Roger Altman

Kaufman, P.J. [1987]. The New Commodity Trading Systems and Methods , John Wiley. Wilder, J. Welles [1978]. New Concepts in Technical Trading Systems , Trend Research.

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