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Forex Strategy Corner: RSI Strategy with FX Options Volatility Filter

By , Quantitative Strategist
30 September 2010 22:36 GMT

The Relative Strength Index is a highly popular across forex trading markets, and historical data suggests that it has had a fair deal of success as a standalone trading strategy in key instances. Yet it is far from perfect and tends to strongly underperform in adverse market conditions. In a past Forex Strategy Corner article we discussed money management in a bid to protect against such adverse moves. Through the following segment we hope to use forex options market volatility expectations to help protect against adverse performance in the volatility-sensitive RSI Strategy.

Relative Strength Index: Strengths and Weaknesses

In a previous Forex Strategy Corner article, we discussed the relative merits of a simple Relative Strength Index strategy. The benchmark system tends to perform well during slower, range-bound price action in a given currency. Yet subsequent market breakouts can and often will erase any gains achieved in a short span of time and lead to large losses.

One can try to protect against this by using fairly aggressive stops, and indeed we saw the strategy improve noticeably when we introduced fixed stop levels in our hypothetical performance backtests. Yet we likewise know that the strategy is particularly sensitive to volatility conditions, and there is reason to believe that a volatility filter could likewise improve performance on the RSI strategy.

Forex Options Market Volatility Expectations: Predicting Market Conditions

Options prices vary on several key factors, and one of the most significant determinants of an option’s price is volatility expectations. An option will become more expensive if traders expect the underlying currency will move substantially through the specified time period. In fact, we can look at an options price and derive the “implied volatility” that tells us exactly how much current options price predicts the currency will move through its expiration. We already use these indices in several DailyFX reports, and it is a natural extension to discuss how they can come in handy for our benchmark RSI strategy.

Forex_Strategy_Corner_RSI_Strategy_with_FX_Options_Volatility_Filter_body_Picture_3.png, Forex Strategy Corner: RSI Strategy with FX Options Volatility Filter

In our weekly Forex Strategy Outlook, we use a specific derivative of implied volatility levels to determine our strategy biases for individual currency pairs.

Volatility Percentile – The higher the number, the more likely we are to see strong movements in price. This number tells us where current implied volatility levels stand in relation to the past 90 days of trading. We have found that implied volatilities tend to remain very high or very low for extended periods of time. As such, it is helpful to know where the current implied volatility level stands in relation to its medium-term range.

We will extend this idea to develop a trading filter for the highly volatility-sensitive Relative Strength Index strategy with the following trading rules:

Forex Relative Strength Index (RSI) Trading Strategy with Volatility Filter

Entry Rule: When the 14-period RSI crosses above 30, buy at market on the open of the next bar. When RSI crosses below 70, sell at market on the open of the next bar.

Filter: Strategy cannot enter trades and must close any open trade if the volatility percentile goes above a specific threshold.

Stop Loss: None by default

Take Profit: None by default

Exit Rule: Strategy will exit a trade and flip direction when the opposite signal is triggered. It will also close any open trades if the volatility filter crosses the aforementioned threshold.

Backtesting our Forex Relative Strength Index (RSI) Trading Strategy with Volatility Filter

Using FXCM’s Strategy Trader software, we will code a strategy based on the RSI and our volatility filter. Though we cannot share our volatility data natively through the platform, the base RSI strategy is available for testing.

View a video guide on strategy backtesting and optimization in Strategy Trader here:

http://forexforums.dailyfx.com/strategy-trader-webinars/220697-basic-backtesting-optimization.html

Download and install the Strategy Trader platform, then import the following code example from FXCM’s Forex Code Source. For a video guide on how to import source code into your Strategy Trader program, see here:

https://admin.na6.acrobat.com/_a205571165/p92478515/?launcher=false&fcsContent=true&pbMode=normal

Forex RSI Trading Strategy With Volatility Filter

We ran this strategy on the EURUSD, USDCHF, USDJPY, and GBPUSD using four different volatility filter values. We assume transaction costs of 3 pips on the EURUSD, USDJPY, and USDCHF and 4 pips on the GBPUSD. Below are the hypothetical equity curves of said strategy run on four different volatility filter thresholds.

Forex_Strategy_Corner_RSI_Strategy_with_FX_Options_Volatility_Filter_body_Picture_6.png, Forex Strategy Corner: RSI Strategy with FX Options Volatility Filter

Though past performance is no guarantee of future returns, the strategy shows promise in trading these select currency pairs. The baseline “Unfiltered” RSI strategy does reasonably well across these four currency pairs in our hypothetical backtests.

Looking at the breakdown between different volatility filter thresholds likewise shows some promise. The most aggressive filter—cutting off trading when individual currency volatility percentiles hit 50 percent or higher—does rather poorly over this time period. This intuitively makes some sense: if the strategy performs reasonably well on its own, anything that takes it out of the market half of the time will likely worsen results. Things become slightly more nuanced when we use higher volatility cutoffs.

The equity curve shown for the 75th Percentile volatility cutoff shows lower final profits than the baseline unfiltered strategy. That being said, the equity curve looks significantly less volatile and in several instances outperforms the baseline strategy. On a risk-adjusted basis, the 75th Percentile filter looks roughly equal to the baseline strategy.

The most interesting result nonetheless comes on the volatility cutoff at the 90th percentile. On both a risk-adjusted and a final-equity basis, this strategy hypothetically outperforms the baseline RSI strategy. That is to say, if we had cut off trading and closed any open trades every time that our percentile hit above 90, we would have theoretically achieved superior results over the baseline RSI strategy.

Applying Our Analysis to Existing Strategies/Trading Styles

Hypothetical backtests show that the RSI strategy performs reasonably well over the past 9 years of trading, and baseline results improve noticeably if we introduce an implied volatility-based filter.

We publish those same volatility numbers every day at 5pm for individual currency pairs on or DailyFX Technical Analysis portal, and traders may follow developments in forex options market implied volatility levels using said page. Though past performance is never a guarantee of future results, our backtests suggest that the RSI strategy tends to do poorly on individual currency pairs when the volatility percentile rises above the 90percent mark.

If you would like to suggest ideas for this topic or any other forex strategy you would like to see in this series, feel free to e-mail author David Rodríguez at drodriguez@dailyfx.com. To be added to this author’s distribution list, e-mail with subject line “distribution list”

View previous articles in this series:

Using Momentum indicator in Currency Trading

Using Seasonality Strategies in Your Trading

Forex Trading Strategy Analysis: Trade with Market Conditions

How do we use Money Management for Moving Average Forex Strategies?

How do we set stops for the Range Trading Strategies?

Using Candlestick Formations in Forex Trading

Written by David Rodríguez, Quantitative Strategist for DailyFX.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.
Learn forex trading with a free practice account and trading charts from FXCM.

30 September 2010 22:36 GMT