The Bollinger Bands and Relative Strength Index (RSI) Strategy

Bollinger Bands and RSI strategy

The strategy of using the Bollinger Bands and RSI is extremely powerful. This is a fresh new series of technical analysis that I have not covered before. For many of the readers who have been following my blog for quite some time, you would have realised that all my posts under the technical analysis section are Ichimoku Cloud charts. While Ichimoku Cloud has its own strength and merits, they usually work best for trending markets or swing trading.

The reason why I decided to do a post on the strategy of Bollinger Bands and RSI is that it allows us to know whether prices are high and overbought or low and oversold. It is as simple as that, but obviously not as easy as the way I have said it. Before you make a buy or sell decision, you can plot on these 2 indicators to provide additional confirmation or disconfirmation. All it takes is 1 minute and you would have generated extra insights by using this strategy.

I don’t proclaim myself as a technical analysis expert or any kind. But I do believe that one should be adaptable and versatile to the different tools, indicators and thinking in technical analysis. There is no fixed system or fixed way of looking at charts. Things change and market changes. Sometimes you use this and other times you use that. Furthermore, putting on different thinking caps can provide additional confirmation, which is commonly known as “confluence”. This can help better time your entry or exit points.

Leading vs Lagging Indicator

Relative Strength Index (RSI) is a leading indicator and Bollinger Bands is a lagging indicator.

Leading indicator means it is designed to precede future price movements. It gives a signal before something happens. I found a good diagram from Babypips that pretty sums up everything about the leading indicator. You can see that the leading indicator sort of gives an early warning signal before a trend reversal occurs. The downside of leading indicators is that they are less reliable and can sometimes lead to false signals. Remember that nothing is an absolute certainty in technical analysis.

Leading Indicator

On the other hand, the lagging indicator provides a signal only AFTER something has happened. While the lagging indicator is more accurate, the bad news is you are probably late at the party when a lagging indicator shows up. Keeping these two simple concepts in mind, let’s dive into the details of what exactly is Bollinger Bands and RSI.

The Mechanics of Bollinger Bands

Bollinger Bands is developed by John Bollinger in the 1980s and it is commonly used to measure the volatility of an asset. Here is how Bollinger Bands looks like on bitcoin.

There are 3 components to Bollinger. The first one is just a simple 20-day moving average which is represented by the middle band. The second and third is the upper and lower bands that are two standard deviations away from the 20-day SMA. That’s all it is to Bollinger. It has much lesser components in comparison to Ichimoku.

What does it mean?

A 20 SMA (red middle line) is just the AVERAGE closing price of the past 20 days. It is really all there is to it. You can check out on Investopedia on how moving averages are calculated.

The upper and lower bands are slightly more complicated since it deals with the study of statistics. Standard deviation measures how far or near the data points are in comparison to the mean. If the standard deviation is low, it means the prices are very close to the mean. If the standard deviation is high, it means prices are spread out far away from the mean. So what dos the upper and lower band signify? What does it mean to say that the upper and lower bands are 2 standard deviations above or below the mean?

The 3-Sigma Rule of Thumb

To appreciate the significance of the upper/lower bands, we have to first understand the 68-95-99.7 rule which is otherwise known as the empirical rule in statistics. The empirical rule states that 68% of the data would fall within 1 standard deviation away from the mean, 95% within 2 standard deviations and 99.7% within 3 standard deviations.

To put this into context, the mean we are talking about in Bollinger Bands is the 20-day simple moving average. The standard deviation is the past 20 data points. Imagine a data set of 20 prices, calculate the mean, calculate the difference between each price data with the mean, square it, sum it up and square root it. That will give the standard deviation figure over the past 20 days.

Bollinger Bands is made up of the upper bands & lower bands which are 2 standard deviations away from the mean. The chances that the price would touch either the upper band or lower band is 13.6%. This can be seen from the above diagram. The chances that price would exceed the upper band or lower band is approximately 2.1%. Usually, in such cases, the price would rebound or retrace back sharply back within the upper and lower bands.

That is the reason why you see the candlesticks are pretty much contained within the Bollinger Bands. This is because 95% of the data are all within 2 standard deviations from the mean. When the price moved BEYOND 2 standard deviations from the mean, it is usually an extreme overbought or oversold position. Think about it, the chances are 5%.

The Mechanics of Relative Strength Index (RSI)

Relative Strength Index or RSI is a momentum oscillator that measures the speed and change of price movement. The RSI oscillates between 0 to 100, where anything above 70 traditionally represents overbought and anything below 30 represents oversold. The formula for computing RSI is as follows.

Image result for formula of rsi

RS stands for Relative Strength. The formula of RS is slightly more tricky. It is the average % gain divided by the average % loss over a certain n period. The traditional setting for RSI is to use a 14-day period. So RS is essentially the average gain in % over the past 14 days divided by the average loss in % over the past 14 days. That is for the first 14 data points. Any price that comes after the 14th data point would have a slightly different calculation.

In computing a simple moving average, the average price would continuously be the average of the past 14 days. The different aspect of RSI is that it takes a smoothed average that puts heavier weighting on the latest data. This is the precise reason why RSI is a leading indicator. It is because the latest price has a significant influence on the value of RSI.

To illustrate, the 14-day simple moving average on day 15 would be the average of prices from day 2 to day 15. the 14-day simple moving average on day 16 would be the average of prices from day 3 to day 16.

In computing the smoothed average on day 15, it would be 13 MULTIPLY by the average price from day 1 to day 14 PLUS the current price on day 15, DIVIDED by 14. In computing the smoothed average on day 16, it would be 13 MULTIPLY by the average price from day 2 to day 15 PLUS the current price on day 16, DIVIDED by 14.

To recap, the summary of how RSI is computed is shown below.

After computing the value of RS, simply sub it into the formula and you would get an RSI value of anything between 0 to 100. The lower the value of RS, the closer RSI approaches towards ZERO. The higher the value of RS, the closer the RSI approaches towards 100. That’s why it’s called an oscillator. Based on the formula above, it would only oscillate between 0 and 100.

If RS is higher, it means the smoothed average gain is higher than the average loss. If RS is lower, it means the average loss is higher than the average gain. So if you see RSI creeping up higher and higher, that means the average gains to losses are getting higher and higher. Vice versa if RSI is sloping downhill, it simply means the average losses are getting higher and higher every day.

The Strategy of using Bollinger Bands and RSI

Now that we have covered both Bollinger Bands and RSI, it’s time to piece them up together and see why this dual strategy is so commonly used among traders and investors.

In Bollinger Bands, we mentioned that prices would always be contained within the upper and lower bands. This is because 95% of the data in a normal distribution would fall within 2 standard deviations from the mean. In the case of Bollinger Bands, we are using the 20-period moving average and 20-period standard deviation.

The traditional way of using Bollinger is to trade for reversals. If a price hits the upper or lower band, it is likely to reverse as prices have already reached the extreme end. You can see from the below diagram that the price of gold sort of bounces between the upper and lower band. Of course, things are not so simple in real life if not everyone else would be making money. But for now, let’s just keep to this simplified version of how Bollinger Bands is used.

In RSI, we mentioned that it is an oscillator that oscillates between 0 to 100. Anything above 70 is considered overbought and anything below 30 is considered oversold. Similarly, RSI can be used as an indicator to give an early signal of a reversal. To illustrate, here is how it works.

Remember that leading indicator provides an early warning signal before a trend reverses. You can see that when RSI hits the overbought region, after a couple of days the trend begin to reverse and slope downwards. Conversely, when RSI hits the oversold region, after a few days the trend begins to reverse and slope upwards. Again, things are not as simple in real life else everyone would be rich. But for now, let’s just take this simplified version of how RSI works.

Now, let’s combined both the Bollinger Bands and RSI together into a single chart.

The strategy of using Bollinger Bands and RSI is to watch for moments when prices hit the lower band and RSI hits the oversold region (Below 30). This would be a good entry price to buy. If you are looking to sell, you can wait for prices to hit the upper band and RSI hits the overbought region (above 70). That’s the simplified theory.

The tricky part about this strategy is that prices can remain overbought or oversold for a long period of time. From weeks to months. Similarly, prices can hover around the upper band or lower band for a long period of time. It doesn’t mean prices immediately reverses upon hitting the upper band or prices immediately reverses when RSI hits the overbought region.

From the above chart, you can see that at times when the price is at the upper band and RSI is above 70, it didn’t reverse. The price continues to increase along with the upper band and RSI continues to hover above 70. Similarly, when the price is at the lower band and RSI is below 30, it didn’t rebound back. There are times when prices continue to fall and stick along the lower band and RSI continues to stay below 30.

That’s why I say things are not as simple as theory, else everyone would be rich. BUT, it does give you a good sense of where prices are at the moment.

RSI Divergence and Price Action

To further enhance our strategy, we have to add in more confirmations. The first confirmation is known as the RSI divergence. This is when prices are making higher highs BUT RSI is NOT making higher highs. OR when prices are making lower lows but RSI is NOT making lower lows.

To illustrate with an example, here is the S&P 500 chart. You can see that before the first big crash came, prices are making higher highs. BUT, the RSI is showing a divergence. It is making a lower high. This is a bearish RSI divergence. Soon after, the S&P 500 market tanked.

This is an example of a bullish divergence. Prices are making a lower low. BUT RSI is making a higher low. Prices rebounded and start moving upwards thereafter.

You can actually learn more about regular and hidden divergence from babypips. They have a pretty nice summary of the divergence cheat sheet. The rule of thumb in RSI divergence is that when drawing the lines connecting swing highs or swing lows, it should be unobstructed. Secondly, to prove that it is a swing high or swing low, the next candlestick should close above the previous price.

The second confirmation is to look at the price action of the candlestick. This means that we do away with all other indicators and just look at the patterns of the candlestick. I have found a pretty good summary of the bullish and bearish candlestick patterns.

To combine it with Bollinger Bands, RSI and RSI divergence, we can observe the behaviour of the candlestick patterns at the point of RSI divergence. In a reversal from a downtrend, what we want to look for is bullish engulfing, a bullish hammer, dragonfly Doji etc. This signifies a strong bullish behaviour and most importantly, the price MUST close above the previous candlestick price. Similarly, when prices are at an all-time high and we are wondering if it will start dropping, we can look for a bearish engulfing candle, hanging man or evening Doji etc. All these provide an ADDITIONAL confirmation to your judgement.

Summary of Bollinger Bands and RSI

In summary, the Bollinger Bands and RSI strategy can provide us with a rough sense of whether the current price is overly high or underpriced. This can be done by observing whether the candles are at the borders of the upper band and lower band. Additionally, we can use RSI which is an oscillator to check whether it is overbought or oversold.

While the theory looks nice and simplified on the surface, it is clearly not sufficient to rely on such logic to make buy/sell decisions. We have to analyse other factors such as whether the overall trend is up or down, the fundamentals and we have covered 2 additional confirmations to enhance this strategy. The first one is RSI divergence and the second one is candlestick patterns.

If you are looking to short, the ideal time to sell would be when the price is at the upper band, RSI is overbought, there is a bearish RSI divergence and the candlestick shows a bearish pattern. If you are looking to buy, the ideal time would be when the price is at the lower band, RSI is oversold, there is a bullish RSI divergence and the candlestick shows a bullish pattern.

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