Bollinger Bands and RSI - Essay Example

Bollinger Bands and RSI Bollinger Bands result from the technique of using moving averages with two trading bands in order to track a stock’s volatility. Unlike using a percentage calculation from a normal moving average, Bollinger Bands simply add and subtract a standard deviation calculation. A band consists of a centerline (exponential moving average) and two price channels, one above the centerline and one below. The edges of the band will expand and contract as the price action of an issue becomes volatile (expansion) or becomes bound into a tight trading pattern (contraction). Traders know that when the stock price continually touches the upper Bollinger Band, the price is thought to be overbought and conversely, when they continually touch the lower band, the prices are thought to be oversold (Investopedia). The Relative Strength Index (RSI) is an oscillator. The purpose of an RSI is to compare the magnitude of recent gains to recent losses in an attempt to determine overbought and oversold conditions of an asset. The RSI is best used as a valuable complement to other indices, for in and of itself it is susceptible to the fact that large surges and drops in the price of an asset will affect the RSI by creating false buy or sell signals. Different RSI settings can allow traders to get more accurate market readings about different strategies that they might wish to use. “Swing traders” might want to set the measured period at 15 days, while those buying to hold for longer times might want to make it equal to 30 or even 50 days. Some traders have found that the RSI works best when it is compared to short-term moving-average crossovers. Using a 10-day moving average with a 25-day moving average, a trader may find that the crossovers indicating a shift in direction will occur very close to the times when the RSI chart is showing either distinct overbought or oversold readings. Simply put, the RSI, sooner than almost anything else, indicates an upcoming reversal of a trend, either up or down (Investopedia).  In our analysis we have made the Bollinger Bands our trade trigger and the RSI our trading confirmation. The two indices must be simultaneously within their respective domains where we desire them for a given buy or sell position, or we ignore the trade signal and hold everything. We have used this strategy so that the “noise” created by volatility indicated by the Bollinger Bands gets reduced by the “high pass filter” of the RSI reading. Simply put, we are looking at once at an individual stock’s performance and at that stock’s industry’s performance. We believe this is an astute way of reducing undue risk by providing us with a more accurate and complete marketplace picture so that we are less likely to be tricked by anomalous circumstances surrounding a stock’s temporary pricing trend. Our Trading Signals: 1. Open Long (L): When the price breaks the bottom band of the Bollinger chart, this is indication to go long, but if and only if the bottom band of the RSI is also broken. 2. Close Long (C): Signaled when the price breaks the top Bollinger band, and RSI at once breaks its top band. 3. Open Short (S): When the price breaks the top band of the Bollinger chart, this is an indication to go short, but if and only if the top band of the RSI is also broken. 4. Close Short (C): Signaled when the price breaks the bottom Bollinger Band, and RSI at once breaks the top band. 5. Ignore Indications to trade (X): Where the trigger indicator is satisfied i.e. a Bollinger band is broken, but is not supported by RSI. (XB: Top BB broken, RSI not) (XT: Bottom BB broken, RSI not) (XR: Repeated Trade*). * No repeated trades are permitted in our analysis. I.E., if an open long signal is given and then would be repeated the next day, then the second signal is ignored. We have taken an aggressive approach in our analysis. We closed short and opened long early on. This was a result simply of following the strategy that we had laid out; we were not attempting to be overly aggressive nor overly conservative and we were not tossed to and fro by emotions. What follows are the results from our analysis’ test phase. All values are done in basis points (TEST VALUES) Position Open price Close Price Profit Position Open price Close Price Profit S1 11.44 10.47 0.97 L2 10.33 11.2059 0.8759 S3 11.09 10.09 1 L4 9.90158 10.8 0.89842 S5 10.93 10.04 0.89 L6 9.8 10.2 0.4 S7 10.57 No Close Total P/L Totals 2.86 2.17432 5.03432 It will be observed that in the test phase, our strategy paid off at least as far as never giving us any losses. Our emergently-aggressive start also paid off, as our closing short for the very first time yielded us our biggest single taking of profits. It should be noted that the final short position was never closed out due to the fact that our indicator and trigger never aligned again during the remainder of our analysed period. Although we ignored certain trade signals that might possibly have yielded profits, we are confident, given our results, that we were not unduly limited by our parameters, but that we cut down on risk instead. Ours is a systematic and unemotional strategy; it does not take undue risks nor does it rely on wild speculations, yet in our test run it generated decent profits while preventing losses. What follows is our strategic forecasting, using our strategy, for the real-world corporation Telefonica. All values are done in basis points (FORECAST VALUES) Position Open price Close Price Profit Position Open price Close Price Profit S1 13.13 11.75 1.38 L1 11.31 11.06 -0.25 S3 11.35 10.39 0.96 L4 10.21 No Close Total P/L Totals 2.34 -0.25 2.09 Our real-world analysis yielded similar results to our test phase. While we did not make as many trades and hence did not take as many profits, and even endured a small loss for one trade, the consistency of our strategy with respect to typically yielding decent profits while minimizing risk and loss remained intact. Again, our final position, this time a long one, was never closed out due to the non-alignment of the indicator and trigger. Our self-imposed limitation forbidding repeat trades prevents the risk of huge losses that we would otherwise be exposed to in a strategy that has no stop orders. Although there were times when bigger profits could have been taken in longer-held positions, for instance holding the Telefonica “S1” all the way to the final “XR” and then trading, the trade off would be exposure to greater risk. Likewise, an opening long position in our Telefonica analysis would have yielded us one of our biggest profits if the position was closed at “S1” but stepping outside of our discipline would have thrown off our tight focus and exposed us to undue risk. The indicator was not aligned with our trigger, so in hindsight we did forego that opportunity for the sake of more stability. We have developed a “middle way” strategy that might not be aggressive enough for those who are the type to invest in futures but is certainly more appealing than the risks of whimsy. References “Bollinger Bands” and “RSI”. Investopedia. Retrieved Dec. 12, 2005. . Read More