The RSI and Bollinger bands are 2 of the most popular forex trading indicators. You can use them both to spot overbought and oversold market conditions when used individually. They can also be used to sport market trends and breakouts. However, the accuracy of these indicators can be improved when combined together to form the RSI and Bollinger bands strategy. If you also include some price action analysis and good money management, you can develop a forex trading strategy with an edge.
What is the RSI?
The relative strength index (RSI) is a forex indicator that measures a currency pairs price performance and indicates whether a reversal in direction is imminent. It’s used to measure the magnitude and speed of price movements, oscillating between zero and 100.
The RSI has a default high zone above 70 and low zone below 30. If the RSI falls below 30, then the market is considered oversold and might start to move upwards. If the RSI goes above 70, the market is considered overbought and might start to fall. This is known as the RSI reversal strategy.
You can also use RSI divergence to try and determine the trend direction. A bullish divergence occurs when the RSI displays an oversold reading followed by a higher low that appears with lower lows in the price. A bearish divergence occurs when the RSI displays an overbought reading followed by a lower high that appears with higher highs in the price.
When you combine both the oversold elements and divergence aspects of the RSI indicator, you can improve the signals. In saying that, you can also get further confirmation by using the Bollinger bands.
What are Bollinger bands?
Just like the RSI, Bollinger bands are a technical indicator that has various uses. Bollinger bands consist of a middle band (which is a moving average) and an upper and lower band. These upper and lower bands are set above and below the moving average by a certain number of standard deviations of price, therefore incorporating volatility.
When the price breaches the upper or lower bands, traders can look for either Bollinger band reversal or Bollinger band breakout trades. We can decide which strategy we will apply by looking at the RSI signals and any candlestick patterns along with support and resistance levels.
How to trade the RSI and Bollinger bands strategy?
In order to trade the RSI and Bollinger bands strategy, we will be looking for instances where both of the indicators are signalling an overbought or oversold currency pair. We want price to be outside either of the bands and the RSI to be in an extreme zone. We will time entry with price action analysis and use sensible money management to maintain a favourable risk to reward ratio on our trades.
- RSI (14) is in the extreme oversold zone (<30)
- Price is below lower Bollinger band (20, 2)
- RSI divergence to the upside (optional)
- Bullish price action
In the GBP/USD 1-hour chart below, all of the conditions for a buy signals have been met. We have price below the lower Bollinger band and the RSI is in the oversold zone. These are both indicators that the market may be losing selling momentum and we might expect a turnaround. A solid support level is formed which price begins to move away from and RSI divergence confirms the start of a significant uptrend. There are multiple hammer candlestick patterns for timing our entry into this trend. We could have placed the stop loss just below the recent support level which is just 10 pips. This uptrend continued for at least an impressive 1,200 pips. You will also see there were other RSI and Bollinger bands signals to buy into this trend on the way up.
- RSI (14) is in the extreme overbought zone (>70)
- Price is above upper Bollinger band (20, 2)
- RSI divergence to the downside (optional)
- Bearish price action
You can see from the GBP/USD 1-hour chart below that the conditions for a sell trade were met. Price is above the upper Bollinger band and the RSI is showing the market is overbought. There bearish price action including a shooting star candlestick pattern. You can see on the way down there were additional opportunities to jump in on this downtrend using the RSI and Bollinger bands strategy. We could have used a 20 pip stop loss just above the resistance level which price is moving away from. This downtrend went on for around 1,900 pips which gave ample opportunity to bag some pips along the way.
RSI and Bollinger bands strategy Pros & Cons
- Can catch some big forex trends
- Filter signals with other indicators
- Any currency pairs and chart timeframe
- RSI and Bollinger bands are free to use
- Takes some practice to master
- Requires some user initiative
- There will be false signals
RSI vs Bollinger bands
The RSI and Bollinger bands are two of the most widely used forex indicators. The RSI is mainly for finding extreme buying or selling conditions where the market may reverse. Bollinger bands can show the trend direction and measure volatility. You could in theory trade breakouts or reversals using each of the indicators but I would combine them together to make sure they both agree before taking a position. Even then, I would want to confirm my entry by looking out for key support and resistance levels.
Conclusion: is the RSI and Bollinger bands strategy any good?
Yes, combing the RSI indicator with Bollinger bands can produce a very powerful forex strategy as you can see from the examples above. You can use the RSI and Bollinger bands strategy to analyse all of your favourite currency pair charts and timeframes to find actionable forex signals.
However, I would not blindly take all of the buy or sell signals without conducting additional market analysis for confirmation. You will also need excellent forex money management and discipline as this can be the difference between a winning and losing forex system.
For example, if you had a stop loss of 100 pips and a take profit of 20 pips, then one bad trade would wipe out 5 winning trades. That’s without even considering trading fees. On the other hand, if you had a stop loss of 20 pips and a take profit of 100 pips, you could have a win rate below 50% and still gain some pips. I would want to cut my losing trades short and let winning trades run, using a trailing stop loss to try and maximise the potential of each winning trade.
If you think the RSI and Bollinger bands strategy is something that you would like to try, you could always test it out on a demo account to see how things go. You can get a free forex demo account from most forex brokers, including IC Markets who have tight spreads and low fees for trading forex. I would always practice any forex strategy on demo at first in order to understand how it works and see if it produces good results before making any commitment.
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