A GREAT TRADING STRATEGY: COMBINING RSI AND BOLLINGER BANDS
We’ve treated so far the Relative Strength Index (RSI) and the Bollinger Bands indicators in two separate projects, explaining how to trade binary options based on their interpretation.
In the RSI’s case, there are two ways to look at any currency pair:
Trade overbought and oversold levels. With this approach, when the market reaches the 70 level, traders consider the move as overbought and will start buying put options. When the price falls, and the RSI breaks below the 30 level, traders buy call options with the expectation being that the price will rise from oversold levels. However, the downside of this approach is that it works only when the market evolves in ranges.
Trade divergences between the price and the RSI. A divergence forms when the price makes two consecutive higher highs in a bullish trend, but the RSI fails to imitate the move. More precisely, the RSI fails to make the second high. That is the moment when it diverges from the price and traders start buying put options. The downside is that the market may stay in a diverged mode more than the trader can remain solvent, and, eventually, it’ll lead to losses.
In the Bollinger Bands’ case, here’s how traders interpret the price action:
They use it as a trend indicator. As such, traders buy call options when the price is in a bullish trend between the UBB (Upper Bollinger Band) and the MBB (Middle Bollinger Band). Or, they buy put options when the price falls.
Traders use it as a volatility indicator. The catch is to measure the distance between the UBB and the LBB bands. When the gap narrows to small levels, a breakout is imminent. What traders do is wait for the price to break above the UBB or below the LBB before buying call or put options.
RSI and Bollinger Bands Together
Statistically, the market spends most of the times in consolidation. Or, in ranges. Pattern recognition traders look for triangles, flags, head, and shoulders and other price formation to form an educated guess about when the consolidation might end. But that’s just one way to trade a market. Another way is to use indicators.
The thing is that there are so many indicators that traders get lost when deciding which one to use. As a result, the chart gets too crowded, and the signals become contradictory. The best way to deal with this is to pick the best indicators from each category and use them together. This is precisely what we try to do with this project: we take the most potent oscillator (the RSI) and the most powerful trend indicator (the Bollinger Bands) and put them together at work on the same chart.
Therefore, the chart is clean, in the sense that the oscillator’s window appears at the bottom of the actual chart and the trend indicator appears on the actual price. That’s enough for our setup.
We combine the strength of a trend indicator and an oscillator in one strategy that has clear rules for:
- Entry – the striking price
- Exit – the expiration dat
- Risk – conservatory and aggressive approaches
The approach is beyond fascinating since we won’t merely use two indicators, but three. Considering the Bollinger Bands indicator’s ability to spot volatility changes, this is one of the best approaches to technical analysis that combines only two indicators.
Before going into technical details, make sure the two indicators to use appear on a chart and consider the time frame too. The time frame is the one that gives the expiration date, so it defines the exit.
It is said you must know your way out of the market before getting in. That’s precisely what we’ll do here.
