Before analyzing this technical tool in detail, I have to clarify that this indicator developed by Larry Connors is not exactly the same as that used in the RSI2 strategy (a simple 2-period RSI), although the strategy that we will see throughout the article has some similarity, although with some additional twist. But let’s not entertain ourselves, let’s start with the preliminaries: what is the ConnorsRSI?
The ConnorsRSI Formula
The ConnorsRSI indicator formula consists of 3 elements:
1-) An RSI of 3 periods, in order to measure the momentum of the price in the short term.
2-) The duration of the series of bullish and bearish price closures, using a scoring system by which a positive point is assigned to the first bullish day and successively a point is added to subsequent bullish days, while in the case of bearish days they start with a -1 and points are subtracted for each negative day that passes. Neutral days receive a score of zero.
An RSI (2) is applied to these streaks in such a way that, the longer an upward streak lasts, the closer this RSI of 100 will be, while the longer a downtrend lasts, the closer the value of this RSI will be from 0.
3-) The third piece of the ConnorsRSI puzzle allows us to measure the relative magnitude of price variations. To do this, we will use a percentile sorting function by which we will compare the percentage performance of the current session with that of the last x sessions (by default, Connors indicates that x = 100, that is, we compare the current performance with those of the last 100 candles), obtaining the percentile that would occupy in the ranking.
Once these values are calculated, all bounded between 0 and 100, we obtain the value of the ConnnorsRSI indicator as to the average of all of them so that:
ConnorsRSI (3,2,100) = [RSI (Close, 3) + RSI (Streaks, 2) + PercentRank (Var%, 100)]/3
Visually the indicator looks like the following:
After developing this indicator, Larry Connors himself performed an analysis of the price behavior for different levels of ConnorsRSI. To do this, Connors used a sample of 6,000 sufficiently liquid stocks and with an average trading volume of more than 500,000 shares per day and classified the average return in the 5 days after the ConnorsRSI touched different ranges of values (0-5, 5-10, 10-15, …, 90-95, 95-100). The result is what you can see in the following graph:
As you can see, the upward performance is triggered by levels of ConnorsRSI lower than 15. Similarly, strong drops occur when the indicator exceeds the level of 90. Therefore, at first glance it seems a good idea to open buy positions if the ConnorsRSI falls below 15, and open short positions if the indicator exceeds the 90 level, holding positions for 5 days.
Although in the next section we will see a somewhat more complex strategy, the truth is that this simple analysis of the price behavior based on ranges of values of an indicator already gives us a fairly accurate idea of its predictive capacity. In other words, this way of analyzing technical indicators is highly recommended.
Pullback strategy with ConnorsRSI indicator
Based on this indicator, Larry Connors developed the so-called Pullback ConnorsRSI Strategy. Initially intended for stocks, the rules of this strategy are the following:
- The stock must be trading above $5. In this way, we remove from the middle all the low-quality stocks, including pink sheets.
- The average daily volume traded in the last 21 sessions must exceed 250,000 shares. In this way, we make sure to trade in liquid stocks and with tight spreads.
- The 10-period Average Directional Index (ADX) value is above 30. With this, we confirm the strength of the current trend.
- The minimum of the current session is 2-4-6-8% below the close of the previous session.
- The session closing is close to the minimum of the day (below 10 or 25% of the range of the candle).
- The value of the ConnorsRSI indicator (3,2,100) is below 5-10-15.
If the above rules are confirmed, we will buy at the opening of the next session by placing a limit buy order 4-6-8-10% below the close of the current session.
The position is closed at the candlestick closing if the value of the ConnorsRSI indicator (3,2,100) exceeds 50-60-70-80. However, here Connors points out that it is convenient not to be very strict with the values because we can see how our profits evaporate without having closed the transaction. Of course, as usual in Connors strategies, the use of stops is not recommended.
As you can see in the previous rules, it is possible to choose different values for the parameters. In my opinion, it is most convenient to adjust the percentages based on the volatility of each asset (for example, using a percentage ATR can be a good idea).
Let’s look at an example of this strategy in action:
As we can see, the Dax closes at 9.002 on February 8, 2016, verifying the entry conditions of the strategy since the candlestick closing is more than 2% below the minimum of the previous session, the closing is close to the day minimums, ConnorsRSI falls below 10 and the ADX is above 30. Therefore, the next day we must place a limited buy order below the close of the session. Although Connors recommends at least 4% below, in this example we will use 2% because it is an index that usually does not present such large movements (remember that the strategy was originally intended for stocks). Therefore, we would place a buy order at 8,821, which is executed close to the session lows of the next day.
Now we just have to wait for the ConnorsRSI to return to 50 or more. In this case, we did not have to wait for 5 sessions (although before starting to raise the market had a retracement) for the indicator to break the indicated level, and the positions are closed at the close of the candlestick in 9203 with a gain of 200 points.
Simply because of the expertise shown by Connors in combining the three components (momentum, duration of up and down runs, sorting of yields over time) into a single indicator, it is worthwhile to analyze this analysis tool.
Additionally, the methodology proposed to study the predictive power of ConnorsRSI can be easily replicated for many other indicators, something that can certainly save us a lot of time when we think we have an indicator that works (at least visually) when the conclusion can really be the contrary.
In short, ConnorRSI is an excellent indicator with which we can experiment and use to develop new trading strategies.