An essential guide to trading with Bollinger Band and RSI

When trading with too many technical indicators, traders can get confused while taking entry and exit decisions.

For example, suppose if you are analyzing Moving Average (MA) as well as Relative Strength Index (RSI).

Then RSI may indicate that the stock is in the overbought zone whereas MA 20 has just crossed the prices from below.

Thus using too many indicators at the same time may confuse the trader whether to enter or exit the stock.

Traders can use the combination of two indicators like Bollinger Bands and RSI to consistently make a profit.

In this blog, we will be discussing a trading strategy using both these indicators.

But before discussing this strategy let us discuss how to trade with Bollinger Bands and RSI:

Bollinger Bands:

Bollinger Bands is a volatility indicator that was created by John Bollinger.

This indicator is mainly used to identify volatility in the market and also overbought and oversold zones.

It consists of 3 lines: Upper Band, Middle Line, and Lower Band.

Upper Band = Middle Band + 2 standard deviation.

Lower Band= Middle Band – 2 standard deviation.

Middle Band = 20-period Moving Average.

How to trade with Bollinger Bands?

1. Identifying Cheap/Expensive stocks:

One should remember that when the stocks’ prices are at the upper band then the stock is expensive and when the stocks’ prices are at the lower band then the stock is cheap.

This means that you can buy the stocks when the prices are at the lower band and sell the stocks when the prices are at the upper band.

2. Squeeze:

When the market is in a consolidation phase then it is less volatile, and the Bollinger bands get squeezed.

This means both the lower and upper bands come near to the 20 days moving average.

This indicates that a new trend is going to start and traders should be ready to enter the market for buying or selling.

As after every contraction phase, there is an expansion phase.

 

3. Breakout:

Another way of trading with the Bollinger Bands is when the break out from the upper band or the lower band.

As we can see from the above chart that when the prices breakout from the upper band, the prices tend to reverse to the downtrend.

On the other hand, when the prices breakout from the lower band, then the prices tend to reverse to the uptrend.

Relative Strength Index (RSI):

Relative Strength Index is a momentum indicator that tells us if the ongoing trend has the strength to continue or not.

The formula for calculating RSI is:

“RSI=100– 100/(1+RS)
RSI = Average Gain / Average loss.”

 

RSI moves between 0 to 100 and its default period 14 days.

Overbought and oversold zone:

RSI above 70 is considered to be an overbought zone and below 30 is considered to be an oversold zone.

When RSI moves below 70 from above then traders should become cautious as the bearish reversal may take place.

Similarly, when the RSI moves above 30 from below then traders should become cautious as the bullish reversal may take place.

Divergences:

Traders can also identify bullish and bearish divergences when trading with RSI.

A bullish divergence occurs when the prices are making higher highs and RSI makes lower highs, whereas bearish divergence occurs when the prices are making lowers lows and RSI makes higher lows.

Now as we know how to use Bollinger Bands and RSI when trading, let us discuss how to use them together when trading:

Using Bollinger Bands with RSI:

Bollinger Bands help us in identifying whether there is volatility or not in the market.

But it does not tell us if the ongoing trend has the strength to continue further up or down.

To determine this, we can use RSI with Bollinger Bands to determine both strength and volatility.

From the daily chart of Nifty 50 we can see that RSI made bearish divergence at the upper band of Bollinger bands and prices got reversed to the downtrend.

Similarly, we can see the formation of bullish divergence at the lower band of Bollinger Bands and how the prices reversed to an uptrend.

Thus we are also getting confirmation with the help of RSI that breakout from the upper band and lower band indicates the reversal of the trends respectively. Apart from this, we should also check whether the prices are at resistance for the bullish reversal to take place or if the prices are at support for the bearish reversal to take place. We can also confirm the reversal by the formation of bullish or bearish candles for a bullish or bearish reversal respectively.