Bollinger Bands

Bollinger Bands

Bollinger Bands, a chart indicator developed by John Bollinger, are used to measure a market's volatility.

Basically, this little tool tells us whether the market is quiet or whether the market is LOUD! When the market is quiet, the bands contract and when the market is LOUD, the bands expand. Notice on the chart below that when price is quiet, the bands are close together. When price moves up, the bands spread apart. 

That's all there is to it. Yes, we could go on and bore you by going into the history of the Bollinger Band, how it is calculated, the mathematical formulas behind it, and so on and so forth, but we really didn't feel like typing it all out. In all honesty, you don't need to know any of that junk. We think it's more important that we show you some ways you can apply the Bollinger Bands to your trading.

Note: If you really want to learn about the calculations of a Bollinger Band, then you can go to

The Bollinger Bounce

One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce. By looking at the chart below, can you tell us where the price might go next?

If you said down, then you are correct! As you can see, the price settled back down towards the middle area of the bands.

What you just saw was a classic Bollinger bounce. The reason these bounces occur is because Bollinger bands act like dynamic support and resistance levels. The longer the time frame you are in, the stronger these bands tend to be. Many traders have developed systems that thrive on these bounces and this strategy is best used when the market is ranging and there is no clear trend.

Now let's look at a way to use Bollinger Bands when the market does trend.

Bollinger Squeeze

The Bollinger squeeze is pretty self-explanatory. When the bands squeeze together, it usually means that a breakout is getting ready to happen. If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then price will usually continue to go down.

Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Based on this information, where do you think the price will go?

If you said up, you are correct again! This is how a typical Bollinger squeeze works. This strategy is designed for you to catch a move as early as possible. Setups like these don't occur every day, but you can probably spot them a few times a week if you are looking at a 15-minute chart. There are many other things you can do with Bollinger Bands, but these are the 2 most common strategies associated with them. It's time to put this in your trader's toolbox.

CalculationBollinger Bands consist of a set of three curves drawn in relation to prices:
The middle band reflects an intermediate-term trend. The 20 day - simple moving average (SMA) usually serves this purpose.
The upper band is the same as the middle band, but it is shifted up by two standard deviations, a formula that measures volatility, showing how the price can vary from its true value
The lower band is the same as the middle band, but it is shifted down by two standard deviations to adjust for market volatility.
Bollinger Bands establish a Bandwidth, a relative measure of the width of the bands, and a measure of where the last price is in relation to the bands.

Lower Bollinger Band = SMA - 2 standard deviations
Upper Bollinger Band = SMA + 2 standard deviations.
Middle Bollinger Band = 20 day - simple moving average (SMA).

Signals: Overbought/Oversold

%B can be used to identify overbought and oversold situations. However, it is important to know when to look for overbought readings and when to look for oversold readings. As with most momentum oscillators, it is best to look for short-term oversold situations when the medium-term trend is up and short-term overbought situations when the medium-term trend is down. In other words, look for opportunities in the direction of the bigger trend, such as a pullback within a bigger uptrend. Define the bigger trend before looking for overbought or oversold readings.

Chart below shows within a strong uptrend. Notice how %B moved above 1 several times, but did not even come close to 0. Even though %B moved above 1 numerous times, these "overbought" readings did not produce good sell signals. Pullbacks were shallow as stock reversed well above the lower band and resumed its uptrend. John Bollinger refers to "walking the band" during strong trends. In a strong uptrend, prices can walk up the upper band and rarely touch the lower band. Conversely, prices can walk down the lower band and rarely touch the upper band in a strong downtrend.

After identifying a bigger up trend, %B can be considered oversold when it moves to zero or below. Remember, %B moves to zero when price hits the lower band and below zero when price moves below the lower band. This represents a move that is 2 standard deviations below the 20-day moving average. Below chart shows within an uptrend that began in March 2009. %B moved below zero three times during this uptrend. The oversold readings in early July and late October provided good entry points to partake in the bigger uptrend.

Signals: Trend Identification

John Bollinger's book also featured a trend-following system using %B with the Money Force Index, also known as the Money Flow Index (MFI). An uptrend begins when %B is above .80 and MFI is above 80. MFI is bound between zero and a hundred. A move above 80 places MFI in the upper 20% of its range, which is a strong reading. Bollinger suggested setting MFI periods at 1/2 the number of Bollinger Band periods, which would be 10. Downtrends are identified when %B is below .20 and MFI is below 20.

Chart below shows with Bollinger Bands (20,2), %B and MFI (10). An uptrend started in late July when %B was above .80 and MFI was above 80. This uptrend was subsequently affirmed with two more signals in early September and mid November. While these signals were good for trend identification, traders would likely have had issues with the risk-reward ratio after such big moves. It takes a substantial price surge to push %B above .80 and MFI above 80 at the same time. Traders might consider using this method to identify the trend and then look for appropriate overbought or oversold levels for better entry points.

Conclusions

%B quantifies the relationship between price and Bollinger Bands. Readings above .80 indicate that price is near the upper band. Readings below .20 indicate that price is near the lower band. Surges towards upper band show strength, but can sometimes be interpreted as overbought. Plunges to the lower band show weakness, but can sometimes be interpreted as oversold. A lot depends on the underlying trend and other indicators. While %B can have some value on its own, it is best when used in conjunction with other indicators or price analysis.

One of the great joys of having invented an analytical technique such as Bollinger Bands is seeing what other people do with it. The following rules covering the use of Bollinger Bands were gleaned from the questions users have asked most often and our experience over 25 years of using the bands.  While there are many ways to use Bollinger Bands, these rules should serve as a good beginning point.

1. Bollinger Bands provide a relative definition of high and low. By definition price is high at the upper band and low at the lower band.

2. That relative definition can be used to compare price action and indicator action to arrive at rigorous buy and sell decisions.

3. Appropriate indicators can be derived from momentum, volume, sentiment, open interest, inter-market data, etc.

4. If more than one indicator is used the indicators should not be directly related to one another. For example, a momentum indicator might complement a volume indicator successfully, but two momentum indicators aren't better than one.

5. Bollinger Bands can be used in pattern recognition to define/clarify pure price patterns such as "M" tops and "W" bottoms, momentum shifts, etc.

6. Tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal.

7. In trending markets price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.

8. Closes outside the Bollinger Bands are initially continuation signals, not reversal signals. (This has been the basis for many successful volatility breakout systems.)

9. The default parameters of 20 periods for the moving average and standard deviation calculations, and two standard deviations for the width of the bands are just that, defaults. The actual parameters needed for any given market/task may be different.

10. The average deployed as the middle Bollinger Band should not be the best one for crossovers. Rather, it should be descriptive of the intermediate-term trend.

11. For consistent price containment: If the average is lengthened the number of standard deviations needs to be increased; from 2 at 20 periods, to 2.1 at 50 periods. Likewise, if the average is shortened the number of standard deviations should be reduced; from 2 at 20 periods, to 1.9 at 10 periods.

12. Traditional Bollinger Bands are based upon a simple moving average. This is because a simple average is used in the standard deviation calculation and we wish to be logically consistent.

13. Exponential Bollinger Bands eliminate sudden changes in the width of the bands caused by large price changes exiting the back of the calculation window. Exponential averages must be used for BOTH the middle band and in the calculation of standard deviation.

14. Make no statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The distribution of security prices is non-normal and the typical sample size in most deployments of Bollinger Bands is too small for statistical significance. (In practice we typically find 90%, not 95%, of the data inside Bollinger Bands with the default parameters)

15. %b tells us where we are in relation to the Bollinger Bands. The position within the bands is calculated using an adaptation of the formula for Stochastics

16. %b has many uses; among the more important are identification of divergences, pattern recognition and the coding of trading systems using Bollinger Bands.

17. Indicators can be normalized with %b, eliminating fixed thresholds in the process. To do this plot 50-period or longer Bollinger Bands on an indicator and then calculate %b of the indicator.

18. BandWidth tells us how wide the Bollinger Bands are. The raw width is normalized using the middle band. Using the default parameters BandWidth is four times the coefficient of variation.

19. BandWidth has many uses. Its most popular use is to indentify "The Squeeze", but is also useful in identifying trend changes...

20. Bollinger Bands can be used on most financial time series, including equities, indices, foreign exchange, commodities, futures, options and bonds.

21. Bollinger Bands can be used on bars of any length, 5 minutes, one hour, daily, weekly, etc. The key is that the bars must contain enough activity to give a robust picture of the price-formation mechanism at work.

22. Bollinger Bands do not provide continuous advice; rather they help indentify setups where the odds may be in your favor.

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Volume : Volume Analysis

Volume

Definition of 'Volume Analysis'

The examination of the number of shares or contracts of a security that have been traded in a given time period. Volume analysis is used by technical analysts as one of many factors that inform their trading decisions. By analyzing trends in volume in conjunction with price movements, investors can determine the significance of changes in a security's price. Volume typically increases as price increases and vice versa; when the opposite occurs, it's called divergence.

Volume is one of the most important technical analysis tools to learn and understand how to apply to price movements. Volume increases every time a buyer and seller transact their stock or futures contract. If a buyer buys one share of stock from a seller, then that one share is added to the total volume of that particular stock. Volume has two major premises:

1. When prices rise or fall, an increase in volume is strong confirmation that the rise or fall in price is real and that the price movement had strength.
2. When prices rise or fall and there is a decrease in volume, then this is interpreted as being a weak price move, because the price move had very little strength and interest from traders.

The chart below of Gold futures shows a strong trend being confirmed by a strong increase in volume:

The chart above of Gold shows that when prices began making new highs, volume increased. As the price of Gold increased, more and more buyers (buying pressure) jumped on board.

Likewise, if prices are heading downward and are making new lows and volume increases, the sellers are becoming more and more interested as price falls (increased selling pressure).

Importance of Volume when Analyzing Price Movements

The following is an extreme illustration of the importance of volume:

• A buyer places a market buy order after hours for 10 shares of stock. The transaction occurs one dollar above the closing price. Therefore, the one dollar price move had 10 shares worth of interest from a buyer.
• A buyer places a buy order for 100,000 shares of stock. This transaction takes place at a price that is one dollar above the current price.

Which example is more bullish? They both increase the last transaction price by one dollar. If a trader didn't use volume, he/she would think that the move was identical from a price chart perspective. Of course, the second example is more bullish because the one dollar more the buyer of the 100,000 shares is willing to pay is significant (the buyer is bullish and is taking a large bet to prove it); whereas, in the second example, 10 shares is insignificant.

Increases or decreases in price along with increased volume isn't always confirming of trend. 

Volume Spikes & Blowoffs

Extreme increases in volume along with extreme rises or falls in price can sometimes be interpeted opposite to regular volume analysis:

• Sharp increases in price and sharp increases in volume can mean bulls have been exhausted, all buyers have bought and there is no one else but sellers; the result is bearish.
• Sharp decreases in price and sharp increases in volume can mean that everyone that wanted to get out of the stock or future has; therefore, there are only buyers left - bullish sign.

The chart below of eBay (EBAY) stock illustrates a volume spike, defined as at least two times the average volume:

Volume extremes occur at bottoms as well, which is shown below in the chart 

A strong understanding of volume is an absolute necessary addition to price analysis. Knowing when price increases or decreases have firm support or knowing when either buyers or sellers have been exhausted is extremely useful when trading. Another way of visualizing volume is Volume Rate of Change  and the Volume Oscillator.

Volume Rate of Change

The Volume Rate of Change indicator measures the percentage change of current volume as compared to the volume a certain number of periods ago. The Volume Rate of Change indicator can be used to confirm price moves or detect divergences. The formula for Volume Rate of Change is expressed below:

• [(Current Volume / Volume n periods ago) - 1] x 100

Generally, the Volume Rate of Change is calculated based on 14-periods for input n, but of course can be modified to any trader preferred period. A chart of the 100 ounce Gold futures is shown below with the 14-day Volume Rate of Change indicator:

 

As the price of Gold was increasing, the Volume Rate of Change indicator was increasing as well, indicating that there was buying interest as prices were rising. When Gold broke above trendline resistance, the Volume Rate of Change indicator surged higher, showing that buyers were extremely interested in buying Gold.
Using volume to confirm price analysis can help a trader make better trading decisions. The section discussing how to interpret Volume would be an excellent addition to this Volume Rate of Change section (see: Volume).

Volume Oscillator

The Volume Oscillator consists of two moving averages of volume, one fast and one slow. The fast volume moving average is then subtracted from the slow moving average. The Volume Oscillator is interpreted using the same principles as volume analysis:

1. An increase or decrease in price accompanied by an increase in volume is considered a sign of strength in the prevailing trend. Therefore, when the fast volume moving average (default 14-period) is above the slow volume moving average (default 28-period), the Volume Oscillator is above the zero line and is confirming price direction, whether it be up or down.
2. An increase or decrease in price accompanied by a decrease in volume is considered a sign of weakness in the prevailing trend. Therefore, when the fast volume moving average is below the slow volume moving average, the Volume Oscillator is below the zero line and is warning that the price direction is lacking strength and conviction.

An example of the Volume Oscillator is presented next in the chart of the E-mini Russell 2000 Futures contract:

The fact that price is making higher highs and higher lows is a bullish sign. When the price increases in the Russell 2000 e-mini is combined with the Volume Oscillator making higher highs and higher lows, a double bullish sign is given.
The Volume Oscillator can be used as a confirmation indicator, as it was above with the Russell 2000 e-mini future, or it can be used to detect divergences.

Volume Oscillator Divergences

Volume Oscillator divergences occur when there is an increase or decrease in price which is accompanied by a decrease in volume. When this divergence occurs, the fast volume moving average (default 14-period) is below the slow volume moving average (default 28-period) and the Volume Oscillator is below the zero line. These divergences are warnings that the current price direction is lacking strength and there is potential for a trend reverse.
An example of a Volume Oscillator divergence is presented below in the chart of the E-mini Russell 2000 Futures contract:

When the price was increasing in the Russell 2000 e-mini, the Volume Oscillator was not confirming the price movement because it was decreasing making repeated lower highs and lower lows. This bearish divergence indicated that the recent price increases were not being made with volume strength. The bearish divergence was confirmed when the e-mini future's upward trendline support was broken. However, when the Russell 2000 e-mini futures contract made its downturn, the Volume Oscillator confirmed the price downtrend by making higher highs and lower lows, a signal that volume was increasing and thus indicating that the trend downward had strength. The Volume Oscillator is a helpful addition to any technical trader's toolbox. Analyzing volume gives traders another viewpoint for analyzing potential trades. 

 

Volume Accumulation

The Volume Accumulation indicator combines volume and a price-weighting that shows the strength of conviction behind a trend; the Volume Accumulation indicator is a helpful tool in uncovering divergences. The formula for the Volume Accumulation formula is shown below:

• Volume x [Close - (High + Low)/2]

The formula only gives positive volume to the day if the close is higher than the midpoint of the high and low. If the close is towards the lower half of the range of the price action, then volume is negative for the day. A chart compares the Volume Accumulation indicator with the On Balance Volume indicator that adds positive volume if the close is higher than the previous close, even if the close is only a penny higher, is given next of the stock:

As can be seen in the chart above, Volume Accumulation was giving a more realistic representation of what the stock of Citigroup was doing - going downward. The logic behind the Volume Accumulation technical analysis indicator is follows:

• An up day on high volume is considered bullish, because volume is being transacted at higher prices; for example, there is an imbalance of supply and demand, demand is more than supply, therefore price increases. The fact that there is much volume shows that the size of the supply and demand imbalance is large.
• A down day on high volume is considered bearish, because volume is being transacted at lower prices. With an imbalance of supply and demand, there being more supply than demand, then prices will go down. Since their is high volume, this is a bearish signal because there were many more stock traders and investors trying to get out of their position and willing to do that by asking a lesser price.

An important use of the Volume Accumulation indicator is to confirm price movements and show divergences between the indicator and prices, signaling a potential reversal in trend.

Volume Accumulation Divergences

Any increase or decrease in price with little volume is to be looked upon with skepticism. The Volume Accumulation indicator helps show instances where price is making new highs or lows, but the indicator is failing to confirm those price moves. Also, the Volume Accumulation technical indicator can confirm price movements.
The chart below of the contract shows examples of these divergences, both bearish and bullish:

High #1 to High #2

The E-mini Russell 2000 future made a lower high; this move lower was confirmed by the Volume Accumulation indicator which made a lower high as well.

Low #1 to Low #2

The emini futures contract made a lower low; however, the Volume Accumulation indicator did not confirm this move. Instead, the indicator made a higher low, a bullish divergence suggesting that the bottom had arrived in the price of the futures contract. This bullish divergence was a strong indication for traders to lessen the size of their short positions or even buy to cover all their short positions.

Low #3 to Low #4

The Volume Accumulation indicator confirmed the price increase in the e-mini future by making a higher low. During periods of confirmation like this, traders feel much stronger about stock or futures positions that are held in the direction of the major market trend.

The Volume Accumulation is a very useful technical analysis tool that combines both price and volume. Other similar technical indicators include Chaikin Oscillator (see: Chaikin Oscillator) and Money Flow Index (see: Money Flow Index).

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(MACD) Moving Average Convergence Divergence

The MACD indicator is one of the most popular technical analysis tools. MACD is an acronym for Moving Average Convergence Divergence. This tool is used to identify moving averages that are indicating a new trend, whether it's bullish or bearish. After all, our top priority in trading is being able to find a trend, because that is where the most money is made.

There are three main components of the MACD shown in the picture below:

1. MACD: The 12-period exponential moving average (EMA) minus the 26-period EMA.
2. MACD Signal Line: A 9-period EMA of the MACD. 
3. MACD Histogram: The MACD minus the MACD Signal Line. 

 

 With an MACD chart, you will usually see three numbers that are used for its settings.

• The first is the number of periods that is used to calculate the faster moving average.
• The second is the number of periods that is used in the slower moving average.
• And the third is the number of bars that is used to calculate the moving average of the difference between the faster and slower moving averages.

For example, if you were to see "12, 26, 9" as the MACD parameters (which is usually the default setting for most charting packages), this is how you would interpret it:

• The 12 represents the previous 12 bars of the faster moving average.
• The 26 represents the previous 26 bars of the slower moving average.
• The 9 represents the previous 9 bars of the difference between the two moving averages. This is plotted by vertical lines called a histogram (the green lines in the chart above).

There is a common misconception when it comes to the lines of the MACD. The two lines that are drawn are NOT moving averages of the price. Instead, they are the moving averages of the DIFFERENCE between two moving averages.
In our example above, the faster moving average is the moving average of the difference between the 12 and 26-period moving averages. The slower moving average plots the average of the previous MACD line. Once again, from our example above, this would be a 9-period moving average.

This means that we are taking the average of the last 9 periods of the faster MACD line and plotting it as our slower moving average. This smoothens out the original line even more, which gives us a more accurate line.

The histogram simply plots the difference between the fast and slow moving average. If you look at our original chart, you can see that, as the two moving averages separate, the histogram gets bigger.

This is called divergence because the faster moving average is "diverging" or moving away from the slower moving average.

As the moving averages get closer to each other, the histogram gets smaller. This is called convergence because the faster moving average is "converging" or getting closer to the slower moving average.

And that, my friend, is how you get the name, Moving Average Convergence Divergence! Whew, we need to crack our knuckles after that one!

Ok, so now you know what MACD does. Now we'll show you what MACD can do for YOU.

MACD Moving Average Crossovers

 The primary method of interpreting the MACD is with moving average crossovers. When the shorter-term 12-period exponential moving average (EMA) crosses over the longer-term 26-period EMA a buy signal is generated; this is seen on the chart below with the two purple lines.

  

Remember that the MACD line (the blue line) is created from the 12-period and 26-period EMA. Consequently:

1. When the shorter-term 12-period EMA crosses above the longer-term 26-period EMA, the MACD line crosses above the Zero line.
2. When the 12-period EMA crosses below the 26-period EMA, the MACD line crosses below the Zero line.

Moving Average Crossover Buy Signal

A buy signal is generated when the MACD (blue line) crosses above the zero line.

Moving Average Crossover Sell Signal

When the MACD crosses below the zero line, then a sell signal is generated.
The prior buy and sell signals get a person into a trade later in the move of a stock or future. A more common buy and sell signal is shown in the graph below

  

Most Common MACD Buy and Sell Signals

MACD Buy Signal

A buy signal is generated when the MACD (blue line) crosses above the MACD Signal Line (red line).

MACD Sell Signal

Similarly, when the MACD crosses below the MACD Signal Line a sell signal is generated.

The MACD moving average crossover is one of many ways to interpret the MACD technical indicator. Using the MACD histogram and MACD divergence warnings are two other important methods of using the MACD.

MACD Histogram

The MACD Histogram is simply the difference between the MACD line (blue line) and the MACD signal line (red line). The MACD histogram is illustrated in the chart below

  

MACD Histogram

The MACD Histogram is simply the difference between the MACD line (blue line) and the MACD signal line (red line). The MACD histogram is illustrated in the chart below

MACD Histogram

The MACD Histogram is simply the difference between the MACD line (blue line) and the MACD signal line (red line). The MACD histogram is illustrated in the chart below

 

The MACD Histogram is simply the difference between the MACD line (blue line) and the MACD signal line (red line). The MACD histogram is illustrated in the chart below

Two important terms are derived from the MACD histogram and are illustrated above in the chart

• Convergence: The MACD histogram is shrinking in height. This occurs because there is a change in direction or a slowdown in the stock, future, bond, or currency trend. When that occurs, the MACD line is getting closer to the MACD signal line.
• Divergence: The MACD histogram is increasing in height (either in the positive or negative direction). This occurs because the MACD is accelerating faster in the direction of the prevailing market trend.

When a stock, future, or currency pair is moving strongly in a direction, the MACD histogram will increase in height. When the MACD histogram does not increase in height or begins to shrink, the market is slowing down and is a warning of a possible reversal. The graph below

The letter "T" represents when the top or peak of the MACD histogram occurs. In contrast, the letter "B" shows when the bottom of the MACD histogram occurs. Notice how closely the tops and bottoms of the MACD histogram are to the tops of the Nasdaq 100 e-mini future.

MACD Histogram Buy Signal

When the MACD histogram is below the zero line and begins to converge towards the zero line.

MACD Histogram Sell Signal

When the MACD histogram is above the zero line and begins to converge towards the zero line.

Note: In the example above, three consecutive days of shrinking MACD histogram from top or bottom served as the buy or sell signals shown with arrows. This is an agressive example. One could wait until the MACD histogram went to zero, but that would be the same signal as the MACD moving average crossover.

The MACD is not only good for buy and sell signals, the MACD can be used for warnings of potential change in the direction of stocks, futures, and currency pairs.

MACD Divergences

Bearish divergence occurs when a technical analysis indicator is suggesting that a price should be going down but the price of the stock, future, or currency pair is continuing to maintain its current uptrend.

Bullish divergence occurs when the indicator is indicating that price should be bottoming and heading higher, yet the actual price action is continuing downward.

These valuable divergences can signal to get out of a long or short position before profits erode. The following chart shows some of these divergences:

High #1 to High #2

Looking at the E-mini S&P 500 future, from High #1 to High #2, the futures contract made higher highs, which is usually viewed as bullish. However, the MACD moving average failed to make a new high. This bearish divergence was an early warning sign of things to come with the contract.

Low #1 to Low#2

In yet another bearish sign for the E-mini S&P 500 futures contract, the future made higher lows from Low #1 to Low #2, which again is usually considered positive. Nevertheless, the MACD technical indicator made a clear lower low from Low #1 to Low #2. This bearish divergence warned of the impending downturn of the contract  and the market as a whole.

Low #2 to Low #3

In addition to bearish and bullish divergences, the MACD can confirm price movement as well. The E-mini S&P 500 futures contract made a substantial lower low which was confirmed by the MACD when it made a lower low as well.

As seen throughout the MACD sections, the MACD is a versatile tool giving clear buy and sell signals and giving warnings of impending price changes.

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( RSI ) Relative Strength Index

Relative Strength Index

One of the most popular technical analysis indicators, the Relative Strength Index (RSI) is an oscillator that measures current price strength in relation to previous prices. The RSI is a versatile tool, it can be used to:

• Generate buy and sell signals
• Show overbought and oversold conditions
• Confirm price movement
• Warn of potential price reversals through divergences

The chart below shows how the RSI can generate easy to follow buy and sell signals:

RSI Buy Signal

Buy when the RSI crosses above the oversold line (30).

RSI Sell Signal

Sell when the RSI crosses below the overbought line (70).

Varying the time period of the Relative Strength Index can increase or decrease the number of buy and sell signals. In the chart below of Gold, two RSI time periods are shown, 14-day (default) and 5-day. Notice how decreasing the time period made the RSI more volatile, increasing the number of buy and sell signals substantially.

There is another way the Relative Strength Index gives buy and sell signals. Given Below-

RSI Divergences

An alternative way that the Relative Strength Index (RSI) gives buy and sell signals is given below:

• Buy when price and the Relative Strength Index are both rising and the RSI crosses above the 50 Line.
• Sell when the price and the RSI are both falling and the RSI crosses below the 50 Line.

An example of this methodology for buying and selling based on 50 Line crosses is given below in the chart-

 For another interesting and under-utilized method for using the RSI indicator for buy and sell signals, see: Stochastic RSI, which combines both the popular Stochastics indicator and the Relative Strength Index. 

Relative Strength Index Confirmations & Divergences

A powerful method for using the Relative Strength Index is to confirm price moves and forewarn of potential price reversals through RSI Divergences.

The chart below contract shows the RSI confirming price action and warning of future price reversals:

Low #1 to Low #2

The E-mini Nasdaq 100 Futures contract's price made a substantial move from Low #1 to Low #2. The RSI confirmed this move, helping a trader have confidence jumping on board the price move higher. The break of trendline of the e-mini future was also confirmed by the trendline break of the Relative Strength Index, confirming that the price move was likely over.

Low #3 to Low #4

A bullish divergence was registered between Low #3 and Low #4. The e-mini Nasdaq 100 future made lower lows, but the RSI failed to confirm this price move, only making equal lows. An astute trader would see this RSI divergence and begin taking profits from their shortsells.

High #1 to High #2

A bearish divergence occured when the e-mini futures contract made a higher high and the RSI made a lower high. This bearish divergence warned that prices could be reversing trend shortly. A trader should consider reducing their long position, or even completely selling out of their long position. The Relative Strength Index is a popular tool for generating buy and sell signals, confirming trends, and warning of impending price reversals.

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Stochastic RSI

Stochastic RSI

 The Stochastic RSI combines two very popular technical analysis indicators, Stochastics and the Relative Strength Index (RSI). Whereas Stochastics and RSI are based off of price, Stochastic RSI derives its values from the Relative Strength Index (RSI); it is basically the Stochastic indicator applied to the RSI indicator. As will be shown below in the chart of the S&P 500 E-mini Futures contract, the Stochastic RSI gives more profitable buy and sell signals and overbought and oversold readings, than the Relative Strength Index:

In the chart above of the contract, the RSI indicator spent most of its time between overbought (70) and oversold (30), giving no buy or sell signals. However, the Stochastic RSI used the RSI indicator to uncover many profitable buy and sell signals. How to interpret the buy and sell signals of the Stochastic RSI is given next in the chart,

Stochastic RSI Buy Signal

Buy when the Stochastic RSI crosses above the Oversold Line (20).

Stochastic RSI Sell Signal

Sell when the Stochastic RSI crosses below the Overbought Line (80).

The Stochastic RSI is an effective and potentially profitable use of the popular Stochastic indicator and RSI indicator. To read more about the Stochastic indicator and the RSI indicator.

• Stochastics

• Relative Strength Index (RSI)

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Stochastic

The Stochastic is another indicator that helps us determine where a trend might be ending.

By definition, a Stochastic is an oscillator that measures overbought and oversold conditions in the market. The 2 lines are similar to the MACD lines in the sense that one line is faster than the other.As we said earlier, the Stochastic tells us when the market is overbought or oversold. The Stochastic is scaled from 0 to 100. 

Stochastic Fast

Stochastic Fast plots the location of the current price in relation to the range of a certain number of prior bars (dependent upon user-input, usually 14-periods). In general, stochastics are used to measure overbought and oversold conditions. Above 80 is generally considered overbought and below 20 is considered oversold. The inputs to Stochastic Fast are as follows:

• Fast %K: [(Close - Low) / (High - Low)] x 100
• Fast %D: Simple moving average of Fast K (usually 3-period moving average)

Stochastic Slow

Stochastic Slow is similar in calculation and interpretation to Stochastic Fast. The difference is listed below:

• Slow %K: Equal to Fast %D (i.e. 3-period moving average of Fast %K)
• Slow %D: A moving average (again, usually 3-period) of Slow %K

The Stochastic Slow is generally viewed as superior due to the smoothing effects of the moving averages which equates to less false buy and sell signals. A comparison of the two stochastics, fast and slow, is shown below in the chart

Full Stochastic Oscillator (Full STO)

The combination of the Slow Stochastic and the Fast Stochastic is called a Full Stochastic. It uses 3 parameters:

The uniqueness of Slow Stochastic is that it uses a "smoothing factor" for the initial %K line that is "n-period" SMA (n is the same number as the middle parameter) of the initial %K line

The Full Stochastic Oscillator is more advanced and more flexible than the Fast and Slow Stochastic and can even be used to generate them. For example, a (14, 1, 3) Full Stochastic is equivalent to a (14, 3) Fast Stochastic while a (12, 3, 2) Full Stochastic is identical to a (12, 2) Slow Stochastic.

Much as the Fast and Slow Stochastics, the number of periods used to create the initial %K line, is defined by the first parameter. %D is again the number of periods that is used to create the signal line.
Readings above 80 act as an overbought signal while readings below 20 act an oversold signal. However, even if the Stochastic Oscillator has reached 80 securities can continue to rise. Similarly, even after it has reached 20 it can continue to fall.

Stochastics Buy & Sell Signals

Stochastics Buy Signal

When the Stochastic is below the 20 oversold line and the %K line crosses over the %D line, buy.

Stochastics Sell Signal

When the Stochastic is above the 80 overbought line and the %K line crosses below the %D line, sell.
Stochastic Fast buy and sell signals are illustrated below in the chart

 Stochastic Slow is presented below in the chart of the contract. Notice how much smoother the %K and %D lines are and how many fewer false signals were given by the Stochastic Slow than were given by the Stochastic Fast indicator.

 In addition to giving clear buy and sell signals, the Stochastic technical analysis indicator is also helpful in detecting price divergences and confirming trend.

Stochastic Price Divergences

Stochastics can be used to confirm price trend. In the example below of the chart, the Stochastic indicator spent most of its time in the overbought area. When Stochastics get stuck in the overbought area, like at the very right of the chart, this is a sign of a strong bullish run. Signals to sellshort would be ignored; however, before the signal not to short was given, many losses unfortunately would have accrued from failed shorting attempts on the left half of the chart.

A powerful and more common occurence is Stochastic divergences. The chart below illustrates Stochastic divergences and confirmations:

Low #1 to Low #2

The Stochastic Slow confirmed the upward movement of gold futures prices by making a higher low.

High #1 to High #2

Gold futures rallied to make a higher high; however, the Stochastic Slow indicator failed to make a higher high, instead it made a lower high. This divergence coupled with a trendline break in the price of gold would be a strong warning to futures traders that the recent rally had probably ended and any long futures positions should be exited or at least scaled back.

Low #3 to Low #4

Gold prices continued its downward tumble, making a lower low at Low #4. On the other hand, the Stochastic Slow indicator was signaling a higher low. This bullish divergence would have warned traders to exit their shortsells, the price of gold had a strong potential of bottoming.

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