Combining Relative Strength Index, Bollinger Bands and EMAs
This lesson will cover the following
- Relative Strength Index
- Bollinger Bands and EMAs
- Combining the three tools
This article presents a trading strategy that combines EMAs, Bollinger Bands and the Relative Strength Index (RSI). It uses a 5-period EMA, a 75-period EMA, 20-period Bollinger Bands and a 14-period RSI. The entry rules are as follows:
Enter long when a bar closes above the 75-period EMA and above the Bollinger Bands’ middle line, while the RSI has a value above 50. Conversely, enter short when a bar closes below the 75-period EMA and the Bollinger Bands’ middle line, while the RSI is at or has broken below 50.
Your stop-loss can be set at a fixed level or trailed. There are three support/resistance levels against which you can place it – the 75-period EMA, the signal bar’s low, or the most recent swing low of the 5-period EMA. You can use the line that lies in the middle of the three as the stop-loss level, and you may wish to add a buffer of several pips so that random noise doesn’t trigger it.
Profit target
Having determined your stop-loss level, and thus your risk exposure, you can proceed to estimate your profit target. In general, traders should aim for a 1:2 risk-to-reward ratio, but there are many variations. You can begin scaling out after achieving a 1:1 ratio and trail your stop for the remainder of the position, or you can aim for double the amount risked (1:2) with your entire position. Your profit target should generally depend on the amount risked – if your stop-loss is too wide, a 1:2 ratio may be difficult to achieve and therefore too risky (inadvisable for novice traders). Stop-loss placement and profit targets should also be determined in accordance with each trader’s preferred money-management system. Most Forex tutors recommend that beginners risk no more than 2% of their trading capital on a single trade.
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Here is an example of the strategy.
As shown in the example above, we enter at 1.0905, just below the close of bar (1), which has crossed beneath the 75-period EMA (blue line) and the Bollinger Bands’ middle line (red line). The RSI has also just crossed below 50. When considering our stop-loss, we see that the most recent 5-period EMA (yellow line) swing high, the high of the signal bar (1), and the 75-period EMA are close together, with the signal candle’s high lying between the other two. Our stop-loss is therefore set at 1.0912 and is visualised by the red vertical line.
Because our capital exposure is relatively small, we will aim for a 1:2 risk-to-reward ratio, or 14 pips. Our profit target (1.0891) is visualised by the green line. Upon reaching it, a trader might choose to scale out and take partial profit while keeping a portion of the trade in the market to capitalise on a possible trend continuation, or they can exit the entire position.