Traders have a large number of strategies to choose from depending on their risk profile and market conditions.
One approach is Larry Connors’ 2-period RSI strategy, which focuses on mean reversion.
This method exploits short-term price reversals, creating unique opportunities in bullish and bearish markets.
This guide will explore the strategy’s foundations, key components, execution rules, associated risks, and practical modifications to potentially enhance profitability.
Contents
Understanding The 2-Period RSI Strategy
Larry Connors developed the 2-period RSI strategy as his take on traditional momentum trading.
Rather than targeting major market tops or bottoms, this approach looks to trade short-term extremes.
The 2-period Relative Strength Index (RSI) allows traders to identify local tops and bottoms that are often influenced by short-term market sentiments rather than long-term trends.
At the heart of the strategy are three essential indicators.
The 2-period RSI is at the heart of this strategy.
The 200-period Moving Average (MA) also provides vital context for the prevailing trend.
An upward slope signals a bullish environment, while a downward slope indicates bearish conditions.
Lastly, the 5-period Moving Average is used to determine exit points.
Identifying Trades
Now that we have the basics down let’s look at how to place both a long and a short trade and when to exit.
Long trades:
As discussed above, long trades are entered when the 2-period RSI drops below five while the price is above the 200-period moving average but below the 5-period moving average.
Short trades:
Short trades are the opposite of the long trades above when the RSI is above 95, and the price is below the 200-period moving average but above the 5-period moving average.
Exit strategies:
There are a few different exit strategies that you can use.
Connors recommended closing the trades in profit when the price crosses through the 5-period moving average.
So, on a long trade, it’s when it crosses above, and on a short trade, it’s when it crosses below.
Connors has no stop losses on the original trade plan, leading to large potential drawdowns.
Another possible exit strategy is using your risk management for a fixed stop loss and taking profit on each trade.
If this is the route you go, keep in mind that this is a momentum trade in a short time frame.
Risks Associated With The Strategy
While the 2-period RSI strategy is unique, it comes with challenges.
One notable concern is the absence of stop-loss mechanisms, which can lead to significant losses in volatile markets.
The short-term focus also adds the risk of being whipsawed on entry.
This can lead to false signals in choppy conditions.
The strategy’s dependence on historical performance is another challenge in the current market environment.
While past backtests have shown promise, recent market conditions have produced mixed results using the pure 2-period strategy.
Another possible risk with the strategy is the instrument that it’s used on.
Illiquid instruments can produce false signals and difficulty entering and exiting at good prices.
This is an easy risk to mitigate; stick to liquid names and instruments, and it becomes a non-issue.
Enhancing The Strategy: Modifications For Improved Profitability
There are a few ways to increase potential profitability and reduce some of the risks associated with this strategy.
First, the threshold and period on the RSI must be altered.
The thresholds are already high, but moving them from 5/95 to something like 2/98 will greatly reduce the number of entries and increase the overextended move.
The chart to the right is the same as above but utilizes a 3-period RSI and a 2/98 threshold.
As you can see, the number of trades has decreased significantly.
Another option is incorporating advanced trend-filtering techniques to enhance the strategy’s reliability.
By adding additional moving averages, such as the 50-period or 100-period, traders can strengthen trend verification.
Utilizing other indicators like the Average Directional Index (ADX) or Momentum Indicator can further confirm strong market trends before entering trades.
Diversification is another way to improve the 2-period RSI.
Applying the strategy across a range of uncorrelated instruments or sectors can effectively spread the momentum risk.
It’s possible that this can cause you to be long/short simultaneously, so depending on the timeframe, you may want to utilize options for that.
There’s more on that below.
Perhaps the best way to improve on this strategy is to include some form of risk management.
Implementing stops can help mitigate drawdowns, and using trailing stops can help secure profits as prices move in your direction.
Multi-time frame analysis can also help traders gain a broader market perspective, making it easier to identify key support and resistance levels to trade off of or into.
Trading The 2-Period RSI With Options
Using options with the 2-period RSi strategy can also help to increase profitability and decrease risk.
First, it should be noted that this will work best with higher time frames but is theoretically applicable to any timeframe higher than 15 minutes.
The best way to use options with this strategy is to trade them long for the leverage.
As a signal fires you would buy an at-the-money or in-the-money call or put (depending on direction).
The goal here is to get as close as possible to a delta of 1/-1 so that price movement increases the option’s value. A few ways to set a stop loss would work here.
The first is to have a fixed dollar value, so if the option loses $X, you would close the trade. The second is based on the underlying.
If the underlying moves against you by X% or $X, you would close the options regardless of where they are.
The third would be letting the option run until the underlying crosses the 5-period average or expires worthless (not recommended).
The take profit on this strategy is the same; as the price crosses the 5-period average, you would exit the position.
As stated at the beginning of the section, the higher the time frame, the better this would work.
While it’s possible to day trade the options profitably, the 4-hour or higher time frame would let you hold overnight and not waste day trades, and it would also give the underlying more room to run.
Final Thoughts
For traders seeking to capture short-term price extremes, the 2-period RSI strategy offers an effective, adaptable method for various market conditions.
This strategy can evolve beyond its initial setup by carefully combining historical insights with practical modifications—such as enhanced entry thresholds, additional trend filters, and options integration.
While the absence of stop-loss is a large detractor of the strategy, implementing risk management is simple and can be done on the fly.
The strategy can be a valuable tool in a trader’s arsenal, allowing them to trade momentum in a new way.
We hope you enjoyed this article on Larry Connors’ 2-period RSI strategy.
If you have any questions, send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
