Ch6. Indicators Explained — RSI, Stochastics, MACD & Bollinger Bands

Overview: Turning Price Into Signals

Indicators process price and volume into formulas that quantify states hard to see by eye — overheating, neglect, momentum. They split into trend-following (MACD) and counter-trend (RSI, Stochastics); use them knowing their character.

Goal of this lesson: Understand the principles of four major indicators and interpret overbought/oversold and divergence in practice.

1. RSI — Relative Strength Index (overbought/oversold)

RSI expresses whether price is overheated or neglected, from 0 to 100, based on the ratio of gains to losses over a period (default 14).

RSI	State	Typical reading
70+	Overbought	Watch for a pullback
30−	Oversold	Expect a bounce
50	Neutral	Trend-direction line

Don’t sell just because it’s overbought. In a strong uptrend, RSI can stay above 70 and keep rising. Remember that counter-trend indicators are powerful in ranges and prone to false signals in strong trends.

RSI Divergence

Bearish divergence: price makes a new high, RSI makes a lower high → weakening momentum
Bullish divergence: price makes a new low, RSI makes a higher low → weakening downside

2. Stochastics — A More Sensitive Oscillator

Shows where the current close sits within the recent high-low range. Made of %K (fast) and %D (slow) lines.

Above 80 overbought / below 20 oversold
In the oversold zone, %K crossing above %D → buy signal
More sensitive than RSI, so more frequent signals → good for short-term, but more false signals

3. MACD — Trend and Momentum at Once

MACD reads trend direction and strength from the difference of a short and long EMA.

MACD line = 12-day EMA − 26-day EMA
Signal line = 9-day EMA of the MACD line
Histogram = MACD line − Signal line

Signal	Meaning
MACD crosses above signal	Buy signal
MACD crosses below signal	Sell signal
MACD above/below zero line	Uptrend/downtrend zone
Histogram growing/shrinking	Momentum accelerating/fading

The histogram is the heart of MACD. Bars shrinking toward zero is a momentum-fade signal that appears before the cross. MACD divergence (price up, MACD down) is a powerful reversal clue.

4. Bollinger Bands — Price Position via Volatility

Bands set at 2 standard deviations above and below a center MA (usually 20-day) visualize volatility.

Price stays within the bands ~95% of the time statistically
Touching the upper band → short-term overheating / lower band → short-term weakness
Squeeze (bands contracting): volatility shrinking → a big move (breakout) is near
Expansion: a strong trend is underway

Bollinger Bands aren’t “touch the top, sell.” In a strong trend price rides the upper band (band walking). More practical is to watch which way price breaks out after a squeeze.

5. Combining Indicators

Combo	Synergy
RSI + MACD	Oversold (RSI) + golden cross (MACD) overlapping raises buy confidence
Bollinger + RSI	Lower-band touch + RSI below 30 → bounce zone
MACD + volume	Cross with volume behind it → higher confidence

More indicators isn’t better. Stacking similar ones (RSI and Stochastics) tricks you into seeing the same signal twice. Combine just 2–3 of different character (trend + counter-trend + volume).

Key Takeaways

Indicators split into trend-following (MACD) and counter-trend (RSI, Stochastics).
RSI 70/30 and Stochastics 80/20 mark overbought/oversold but give false signals in strong trends.
MACD reads trend and momentum via the cross, histogram, and zero line.
A Bollinger squeeze foreshadows a big move; divergence is a powerful reversal clue across indicators.
Combine 2–3 indicators of different character — avoid overuse.

Next lesson: At last, the Ichimoku Cloud. We dissect each component — how its five lines and cloud add the dimension of “time and balance” to trend.