Relative Strength Index (RSI) indicator

An RSI (Relative Strength Index) mean reversion strategy assumes that when an asset becomes extremely overbought or oversold, its price will statistically "revert" back to its average. Calculating and implementing this strategy involves determining the RSI, identifying reversal thresholds, and executing trades based on those levels. [1, 2]

Calculate the RSI

The RSI itself is a momentum oscillator calculated on a scale of 0 to 100. The standard lookback period is 14 days, though mean reversion strategies often use faster 2-period lookbacks.

The mathematical formula is: (RSI=100-\frac{100}{1+RS})

Where RS (Relative Strength) is calculated as: (RS=\frac{\text{Average\ Gain}}{\text{Average\ Loss}})

Note: For the first calculation, simple averages are used. For subsequent periods, the calculation relies on smoothed moving averages to account for previous data.

Identify Reversal Thresholds

In a mean reversion model, you are looking for extremities where the asset's price has moved too far in one direction and is likely to bounce back.

• Standard Reversion Settings (14-Period):
  • Overbought (RSI > 70): Indicates the asset is heavily bid up; wait for the RSI to drop below 70 as a signal to Sell or Short.
  • Oversold (RSI < 30): Indicates heavy selling pressure; wait for the RSI to rise above 30 as a signal to Buy or Long. [1, 2, 3]
• Fast/Aggressive Settings (2-Period):
  • Overbought: RSI crosses above 90.
  • Oversold: RSI drops below 10. (In strong uptrends, a dip below 10 is considered a prime buying opportunity for a short-term bounce). [1, 2, 3]

Setup Trading Execution

The core logic for a basic RSI mean reversion trade revolves around the crossing of these boundaries: [1]

• Long Entry: The asset’s RSI is oversold (e.g., < 30) and crosses up over the threshold.
• Short Entry: The asset’s RSI is overbought (e.g., > 70) and crosses down under the threshold.
• Exit Strategy: Close the position when the RSI crosses back into neutral territory (e.g., 50) or by using a predefined stop-loss (e.g., 1-2% from your entry price). [1, 2]

Key Considerations & Resources

Because market environments change, mean reversion algorithms must be backtested properly. If you are looking to fine-tune your approach, you can explore.

• The Reverse RSI Trading Strategy evaluates price differences mathematically rather than relying strictly on the output oscillator.
• Algorithmic traders discussing the popular RSI(2) mean reversion note that trade quality and statistical robustness are vital to avoid false signals.