Let me explain with the help of an example. We all know - when RSI crosses 30 on the downside, the stock is oversold and you are supposed to buy. Similarly, when RSI crosses 70 on the upside, the stock is overbought and you are supposed to sell. If you go by this algorithm, there is only a 50% chance that your day will be profitable. I have back tested this for the last 10 years on NIFTY and hence claiming the same. So guess what, such a popular ideology doesn't give you any edge more than the chances of getting a heads on coin toss. And the same is true with almost every technical indicator out there. Good for nothing!!
But there is one thing that will give you the edge atleast for the day. What if the cross numbers are closer but different from 30 and 70. Finding those specific numbers is called parameter optimization and can be the differentiator between profit and loss for the day.
Let's build some premises for us to run few tests -
- RSI on the downside will be plotted on the x-axis and will range from OverSold 5 to 45.
- RSI on the upside will be plotted on the y-axis and will range from OverBought 55 to 95.
- Profit/Loss for the day will be plotted on the z-axis considering you buy when stock is OverSold and you sell when stock is OverBought.
After back testing it for today, here are my results -
So if you have followed the age old rule of OS30 and OB70, you would have ended up with -2.9. A loss for the day. But if you had invested just a bit in parameter optimization you would have gone for the levels OS25 and OB80 giving you a handsome profit of 33.15 on NIFTY. Hope this hits home. Let me close this by giving you a neat table data, just to make things crystal clear!
