A Simple But Effective Relative Strength Index/bollinger Bands Strategy

[⭐ analyst75]

“I am adhering to a positive expectancy model and prudent rules of risk management, therefore I have confidence in taking each and every trading signal.”

The Relative Strength Index (RSI) – which has many uses - is a popular tool among Forex traders. However, using it in a conventional way mayn’t serve our best interest. If the conventional use were effective, many traders wouldn’t be losing. The conventional use makes us buy when the indicator is oversold and sell when it is overbought.

Another indicator in consideration is the Bollinger Bands (BB), which is also popular. Its conventional use makes us buy when the lower Band is tested by the price and sell when the upper Band is tested by the price. Also, many traders fail using this approach. Why?

This is because the Forex market tends to move strongly in one direction. When a major bias is assumed, it can go on for weeks, months or years; having transitory corrections along the way. This is especially true of certain crosses and pairs that are often ignored by the mainstream traders. For example, the AUDJPY on 4-hour chart reached a demand zone at 93.00 on May 21, 2014. After this, an upward journey was assumed. The BB had had its lower Band tested and the RSI went into the oversold region and an indication to go long was seen, as it were. Many a trader would’ve gone long.

The price then went up by over 120 pips, testing the upper Band of the BB on May 27, 2014. Was that a time to go short? Many a trader would’ve gone short, and of course, gotten kicked in the butt. In contrary to the expectation of a reversal, the price went further upwards by another 160 pips, testing the upper Band of the BB many times along the northward journey, fooling the traders that a reversal would happen (especially when the RSI sauntered into the overbought region).

What can be done to avoid this kind of scenario and make our trading more profitable? When a pair or cross is trending seriously in one direction, we’d do well to trade in its favor rather than trading against it. Therefore, we want to do something that goes contrary to the conventional thought, but which would make us experience some positivity.

Let’s go back to the example of the AUDJPY on May 27, 2014. The most preferable action to have been done was to go long. On June 24, 2014 (that was the date on which this article was being prepared), the price on the AUDJPY pushed the lower Band of the BB downwards vigorously while the RSI period 14 went below the level 40. What should we do? Sell.

Conversely, this means that we want to go long when the price touches the upper Band of the BB vigorously and the RSI goes above the level 60.

Using the BB and the RSI in conventional ways invariably result in low hit rates; whereas using it in contrary to the conventional thought would improve the hit rates. The conventional method is not totally useless, but the hit rates are lower. One may use optimal stops and targets, plus the maximum duration of open trades, as befitting a swing trading method. It’s a bad habit to truncate our trade before it hits the stop or the target or before the maximum trading duration expires. The position sizes should limit us to about 0.5% or 1% risk per trade and the use of trailing stop is optional.

When trading a mechanical strategy, we want to remain mechanical in our approach. Application of emotional discretion to a mechanical strategy may lead to errors, especially when we’re trying to tweak it for optimization.

When we peek at our charts – irrespective of the instruments – we peek at money-making setups. Nevertheless, it’s not every setup we’ll trade. We want to take fewer setups so that our stakes could be limited. We’re interested in harnessing gains, not in making infallible forecasts. If we accept negativity in our career, we’ll later be rewarded with positivity.

The quote above is from Richard Weissman. Another quote from him ends this article.

“It is more important to be the best risk manager and best position manager than it is to develop the most robust rules for trade entry.”