Price psychology analysis or technical analysis as it is popularly called uses the historical price data with mathematical formulas to understand, interpret and predict the movement in the price of any particular financial instrument.
There are a plethora of tools/ indicators available to analyse any particular instruments price as per the technical analysis tools universe. Technical analysis is more of an art than an exact science which needs to be perfected by one.
Any trader has to use a technical trading strategy which is a combination of different tools preferably customized for different instruments; a back-testing of the tools would help better select these tools for technical strategy. Via this write up we attempt to take you through one such combination of technical tools to be used for an instrument.
The results of a back-testing for FTMIB / Italy 40 stock index as it’s also called:
Bollinger band is a technical indicator tool invented by John Bollinger who was himself a very renowned technical trader. The Bollinger band has 2 lines one above the moving average and one below the moving average which define 2 standard deviations from the moving average both above and below the moving average. While the bands adjust themselves to new levels as per the trend of the price, the price of any instrument is considered to be overbought when it touches the top line of the Bollinger band & oversold when it touches the lowest line of the Bollinger Band.
As one can see above following the same rules on an hourly chart for Italy 40 one would have made a profit on 76% of the trades taken; the exit from long or short positions are done when the opposite end of the Bollinger is touched. The strategy gives us a max loss of 4K and the total profit of 22K on a capital of 100,000.
We can see in the example below the entry for sell position is at the yellow downwards pointing arrow and the exit of the sell positions, as well haste fresh buy position is taken at the blue upwards pointing arrow.
The moving averages give anindication of the trend in the instruments price, hence we can also initiatebuy only or sell only positions as per the long-term trend in the market.
Relative Strength Index:
The Relative Strength Index (RSI) which was developed by J. Welles Wilder, measures the velocity of a security’s price movement to identify overbought and oversold conditions. One can use RSI to recognize potential turn around in price of an instrument to help a trader make entry/exit decisions.
The RSI range is between 0 – 100 levels. The RSI indicator uses the average gains and average losses over the last 14 periods to create the index. When the RSI indicator falls to the level of 30 or below, it indicates a highly oversold level for the price of an instrument. Similarly, an RSI value greater than 70 is indicative of overbought levels of price.
The price data for the above shows a success rate of 84% and a net profit of 18.4K when we buy & exit short trades at oversold levels of RSI & enter short positions alongside exiting long positions at overbought levels on RSI. The graph below shows an example as to when the buy and sell trades is initiated:
When both these tools are used in combination as a technical strategy to take buy and sell entry & exit decisions we have the following results:
Combination of the RSI & Bollinger Bands:
When both RSI & Bollinger Bands are used to make the buy & sell decision we have a higher profit as compared to both the instruments used individually. The number trades are less than both the instruments used individually.
This strategy enters a buy trade & exits short positions when the Bollinger bands lower band is broken on the downside as well as when the RSI reaches oversold levels of 30 or below that and similarly enters fresh short position whilst exiting long trades when the Bollinger bands upper band is breached on the upside and RSI crosses above 70 levels simultaneously.
An example of the short & long trade entry & exit points can be seen in the chart below:
Hence we can use a combination of both the technical indicators as a strategy for doing higher probability trades as well as increasing the percentage returns on the capital invested for trading. A combination of indicators strategy is most of the times a better technical strategy to follow than using one single technical indicator as trading strategy.