The Bollinger bands indicator is one of the few indicators that represent both the volatility and the price trend of the analysed security. As a result, Bollinger bands eliminate the need for other indicators, such as trend indicators.
The best way to practice the Bollinger bands strategy is to start with a demo account.
Volatility and trend are two main components used to trade effectively. While there is money to be made within ranging markets or sideways markets, traders can expect big returns during a strong trend.
Volatility is just a measure of the trend’s speed. When volatility picks up, you can expect to see a trend following later. As a result, the Bollinger bands can signal volatility followed by a trend formed in price.
Another widely used oscillator is the RSI (relative strength index) indicator, which moves within fixed values and depicts overbought and oversold conditions. While this indicator is typically used within ranging markets, it is also effective during trends.
When the markets are oversold or overbought during a bearish or a bullish trend, respectively, we can anticipate a correction to the price. While the RSI does not signal a trend change, at the very least, the RSI oscillator can signal when price is likely to change direction.
Trading strategy using Bollinger bands and RSI
The main principle of combining Bollinger bands and the RSI indicator is to pick turning points in price. “Turning points” does not mean anticipating trend changes but merely trading both the correction in price trends as well as trend continuations.
The best way to understand it, is to know how the Bollinger bands work as this is the indicator that does most of the work when trading based on this strategy.
The Bollinger bands come with a default setting of 20 and 2. The 20 value is the look back period of the simple moving average. The value of 2 refers to the two standard deviations from the 20-period moving average.
Thus, when price is volatile, you can expect the upper or lower bands to be breached, especially when volatility picks up. You can typically see price breaching the upper or the lower bands.
As we know, volatility precedes trends. Therefore, we simply look for volatility to start expanding near the tops or at bottoms. Prior to this expansion, we can see volatility dropping. This results in the Bollinger bands contracting. Thus, we know the two main components to watch out for on the Bollinger bands.
Look for volatility to contract after a strong rally or a decline, and then look for the Bollinger bands to widen near the top or the bottom.
Bollinger Bands + RSI strategy rules
The trading rules are very simple and should be obvious by now. First, add the Bollinger bands with the standard settings of 20, 2 on the price chart. Then, add a 14 period RSI, which is the standard setting for the oscillator as well. Once you have both these indicators applied to the chart, look for potential trading opportunities when the following rules are met.
For long positions, first look at the chart and identify a price that has fallen sharply. Then, wait until price enters into a sideways trend. Sometimes, price can consolidate into the range for a long period of time. Therefore, patience is an essential aspect for this strategy.
Once the range has been established at the bottom, look for the RSI indicator to post a divergence. A divergence at the low, or bottom, of a trend is when price makes a new low but the RSI indicator posts a higher low. This is also known as the bullish divergence.
At this point, the Bollinger bands should contract, representing the sideways range. Then, simply plot the range high and wait for the price to breakout from it. With the bullish divergence identified on the RSI indicator, take long positions with stops at the previous low.
Take profit can be set at 1:2 at the very least, and after the price moves 50% toward the target, move your stop losses to breakeven or even a few pips higher from your entry price level.
The above chart shows the price declined and then entered into a range. Within this sideways range, we then identified the bullish divergence formed by the RSI. After this signal was formed, we waited for the price to breakout from the range high.
Stops were set at the range low, and then the target was set to 1:2. When price rallied to 50% of the objective, we moved the stops to break even. This resulted in no risk being left on the table. Eventually, the price reached the 1:2 target level.
The trading rules for the short position are the opposite of the long positions. In this case, we first look for a bullish trend. Following this, near the top of the rally, we look for consolidation.
When the price enters into the sideways range near the top, we look to the RSI indicator to signal a bearish divergence. The bearish divergence on the RSI is where price makes a new high but the RSI makes a lower high. This discrepancy in the RSI signals prices could be ready to correct the trend.
At the same time, we look to the Bollinger bands. Here, the bands need to start contracting and thus representing slower volatility. We then plot the high and low of the range formed near the top. Short positions are taken near the lower end of the range with stops at the upper range.
The risk reward set up will be 1:2, and as with the example in the long position, you can cover your stop losses to break even when the price reaches 50% of the target level.
The above short position example shows how price initially rose steadily. After this rally in price, we noticed volatility was relatively weaker as the bands briefly contracted. At the same time, price made a higher high but the RSI posted a lower high.
This bearish divergence signal within the ranging markets gives us the indication to go short on a break down below the lower end of the range. Based on the stops and the entry level, we then set the target and the 50% level as well.
Note that, in the above example, we did not set the stop loss to the extreme high. There is some subjectivity involved as we chose the more reasonable high that was formed because, when the range is too wide, you can expect the trade to become riskier.
However, with enough practice, you will soon be able to pick the right high and low range. We can then see that price eventually declines and reaches our 1:2 target level.
Comments by traders
The Bollinger bands and RSI strategy can be used as a simple way to enter a trade right before volatility expands. The simplicity of this trading strategy is that it can be used on time frames of H1 and H4. This makes the strategy easy to follow up, especially for day traders.
Forex traders can combine the information from these two indicators to build a simple yet effective trading strategy. Because both indicators are available on almost all trading platforms, it also makes the system convenient. You can share your strategy in the comments below.