Trading Bollinger Bands®

Bollinger Bands - Part ll

Strategies for Trading Bollinger Bands

Using Bollinger bands as an indicator for trading can add extra ammunition to the arsenal of existing traditional patterns of technical analysis, such as double tops, double bottoms, ascending triangles, symmetrical triangles, head and shoulders top or bottom, etc., which can help to improve your trading techniques.

Trading Bollinger Bands can help you understand certain characteristics of a stock such as the high or low of the day, whether or not the stock is trending, or even if it is volatile or not.

"Building Cause"

On occasion when trading Bollinger bands, you will see the bands coiling very tightly which indicates the stock is trading in a narrow range. This is the trigger to watch for a price breakout or breakdown. Many times, large rallies begin from low volatility ranges. When this happens, it is referred to as "building cause". This is the calm before the storm.

"Automatic Rally"

When trading Bollinger bands a common strategy, particularly for options, involves a double bottom setup. The initial bottom of this formation tends to have strong volume and a sharp price pullback that closes outside of the lower Bollinger band. These types of moves typically lead to what is called an "automatic rally". The high of the automatic rally tends to serve as the first level of resistance in the base building process that occurs before the stock moves higher. After the rally commences, the price attempts to retest the most recent lows that have been set in order to test the vigor of the buying pressure that came in at that bottom. Many bollinger band technicians look for this retest bar to be inside the lower band. This indicates that the downward pressure in the stock has subsided and that there is a shift now from sellers to buyers. Also pay close attention to the volume, you need to see it drop off dramatically.

Riding the Bands

Buy OR Sell Signal

The single biggest mistake that many users make when trading Bollinger bands, is that they sell the stock when the price touches the upper band or conversely buy when it touches the lower band. John Bollinger himself stated that a touch of the upper band or lower band itself does not constitute a buy or sell signal. Using other technical indicators and pattern recognition, you can actually trade in the direction of a stock that is closing above or below the upper and lower band.

Take a look at the example below and notice the tightening of the bollinger bands right before the breakout (the tendency here is to sell and move out of the trade), a price penetration of the bands cannot alone be considered a reason to short a stock or sell it. Notice how the volume exploded on that breakout and the price began to trend outside of the bands. These can be extremely profitable setups.

BSBollinger band example



The Middle Band

The middle band is set as a 20 period simple moving average as a default in many charting applications. Every stock is different and some will respect the 20 period and some will not. In some cases when trading Bollinger bands , you will need to modify the simple moving average to a number that the stock respects. This is curve fitting but we want to put the odds in our favor. You can use this line to represent areas of support on pullbacks when the stock is riding the bands. You could even add an additional position in the stock using this technique.

Conversely, the failure for the stock to continue to accelerate outside of the bollinger bands indicates a weakening in strength of the stock. This would be a good time to think about scaling out of a position or getting out entirely. Additionally, we should look for higher highs and higher lows as we are trading Bollinger bands.

Bollinger Band Squeeze

Another strategy for trading Bollinger bands is to gauge the initiation of an upcoming squeeze.

The Bollinger squeeze is pretty self explanatory. When the bands “squeeze” together, it usually means that a breakout is going to occur. 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 the move will usually continue to go down.

bollinger squeeze-1



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, the price will probably continue to go up.

bollinger squeeze-2



This is how a typical Bollinger Squeeze works. This strategy in trading Bollinger bands is designed 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.

Using the Band width in a Bollinger Squeeze

John Bollinger created an indicator known as the Band width. This formula is simply (Upper Bollinger Band Value - Lower Bollinger Band Value) / Middle Bollinger Band Value (Simple moving average).

The idea when trading Bollinger bands, using daily charts, is that when the indicator reaches its lowest level, you can expect the volatility to increase. The bands begin to tighten. This type of squeezing action of the bollinger band indicator foreshadows a big move. You can use additional indicators to help compliment the Bollinger band. These indicators could supplement direction of the trade:-

• such as volume expanding,

• or did the accumulation distribution indicator turn up,

• or does the price range narrow on down days?

These additional indications add more evidence of a potential bollinger band squeeze.

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. If this is the case, then by looking at the chart below, we can determine that the price will go down.

bollinger bounce-1



As you can see, the price settled back down towards the middle area of the bands.

bollinger bounce-2



This is a classic Bollinger bounce. The reason these bounces occur is because Bollinger Bands act like mini support and resistance levels. The longer the time frame you are in, the stronger these bands are. Many investors trading Bollinger bands 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.

Using Bollinger Band "Bands" To Gauge Trends

Bollinger bands are one of the most popular technical indicators for traders in any financial market - stocks, bonds or foreign exchange (FX). Many investors trading Bollinger bands use them primarily to determine overbought and oversold levels, selling when price touches the upper Bollinger band and buying when it hits the lower Bollinger band. In range-bound markets, this technique works well, as prices travel between the two bands like balls bouncing off the walls in a pinball machine.

EUR/GBP



Sell Signals

As John Bollinger was first to acknowledge when trading Bollinger bands, "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". Price often can and does "walk the band". In those markets, traders who continuously try to "sell the top" or "buy the bottom" are faced with an excruciating series of stop-outs or worse, an ever-mounting floating loss as price moves further and further away from the original entry.

AUD/USD



Gauging Trends Using Bollinger Bands

Perhaps a more useful way for trading Bollinger bands is to use them to gauge trends.

Definition of Trend

Understanding the meaning of trend and trend analysis is important in the comprehension of gauging trends in trading Bollinger bands.

Trend

- a general direction in which something tends to move;

- the general direction in which something tends to move;

- a general tendency or inclination.

Eg."the trend of the stock market"

Trend Analysis

An aspect of technical analysis that tries to predict the future movement of a stock based on past data. Trend analysis is based on the idea that what has happened in the past gives traders an idea of what will happen in the future.

Trend analysis tries to predict a trend like a bull market run and ride that trend until data suggests a trend reversal (e.g. bull to bear market). Trend analysis is helpful because moving with trends, and not against them, will lead to profit for an investor.

There are three main types of trends: short-, intermediate- and long-term.

"The Trend is Your Friend"

This old saying is a very worthwhile piece of advice for any trader. Determining what the trend is and when it has changed is a basic building block for successful trading.

A stock may trade for long periods in a trend, albeit with some volatility from time to time. To better see the trend, traders use the moving average to filter the price action. This way, traders can gather important information about how the market is trading. For example, after a sharp rise or fall in the trend, the market may consolidate, trading in a narrow fashion and criss-crossing above and below the moving average. To better monitor this behavior, traders use the price channels, which encompass the trading activity around the trend.

We know that markets trade erratically on a daily basis even though they are still trading in an uptrend or downtrend. Technicians use moving averages with support and resistance lines to anticipate the price action of a stock. Upper resistance and lower support lines are first drawn and then extrapolated to form channels within which the trader expects prices to be contained. Some traders draw straight lines connecting either tops or bottoms of prices to identify the upper or lower price extremes, respectively, and then add parallel lines to define the channel within which the prices should move. As long as prices do not move out of this channel, the trader can be reasonably confident that prices are moving as expected.

Trend as Deviance

One standard cliché in trading is that prices range 80% of the time. Like many clichés this one contains a good amount of truth since markets mostly consolidate as bulls and bears battle for supremacy. Market trends are rare, which is why trading them is not nearly as easy as it seems. Looking at price this way we can then define trend as deviation from the norm (range).

The Bollinger band formula consists of the following:

BOLU = Upper Bollinger Band

BOLD = Lower Bollinger Band

n = Smoothing Period

m = Number of Standard Deviations (SD)

SD = Standard Deviation over Last n Periods Typical Price (TP) = (HI + LO + CL) / 3

BOLU = MA(TP, n) + m * SD[TP, n]

BOLD = MA(TP, n) - m * SD[TP, n]

At the core, Bollinger bands measure deviation. This is the reason why they can be very helpful in diagnosing trend when trading Bollinger bands. By generating two sets of Bollinger bands - one set using the parameter of

"1 standard deviation" and the other using the typical setting of,

"2 standard deviation" - we can look at price in a whole new way.

In the chart below we see that whenever price channels between the upper Bollinger bands +1 SD and +2 SD away from mean, the trend is up; therefore, we can define that channel as the "buy zone". Conversely, if price channels within Bollinger bands –1 SD and –2 SD, it is in the "sell zone". Finally, if price meanders between +1 SD band and –1 SD band, it is essentially in a neutral state, and we can say that it's in "no man's land".

One of the other great advantages of trading Bollinger bands is that they adapt dynamically to price expanding and contracting as volatility increases and decreases. Therefore, the bands naturally widen and narrow in sync with price action, creating a very accurate trending envelope.

AUD/USD-1



Bollinger Bands for Trend Traders and Fade Traders

This technical tool when trading Bollinger bands can be used by both trend traders who seek to exploit momentum and fade traders who like to profit from trend exhaustion. Returning back to the AUD/USD chart just above, we can see how trend traders would position long once price entered the "buy zone". They would then be able to stay in trend as the Bollinger band "bands" encapsulate most of the price action of the massive up-move.

The Logical Stop-Out Point

The logical stop-out point is different for each individual trader, but one reasonable possibility would be to close the long trade if the candle turned red and more than 75% of its body was below the "buy zone".

Using the 75% rule is obvious since at that point price clearly falls out of trend.

However, when trading Bollinger bands as in the second condition, the candle must be red so as to prevent the trend trader from being "wiggled out" of a trend by a quick probative move to the downside that snaps back to the "buy zone" at the end of the trading period.

Note how in the following chart the trader is able to stay with the move for most of the uptrend, exiting only when price starts to consolidate at the top of the new range.

AUD/USD-2



Bollinger band "bands" can also be a valuable tool for traders who like to exploit trend exhaustion by picking the turn in price. Note, however, that counter-trend trading requires far larger margins of error as trends will often make several attempts at continuation before capitulating.

Therefore trading Bollinger bands as seen in the chart below, we see that a fade trader using Bollinger band "bands" will be able to diagnose quickly the first hint of trend weakness. Having seen prices fall out of the trend channel, the fader may decide to make classic use of Bollinger bands by shorting the next tag of the upper Bollinger band. Putting the stop above the swing high will practically assure the trader of a stop-out as price will often make many probative forays to the top of the range, with buyers trying to extend the trend. Here is where the volatility property of trading Bollinger bands becomes an enormous benefit to the trader. By measuring the width of the "no man's land" area, which is simply the range of +1 to –1 SD from the mean, the trader can create a quick and very effective projection zone which will prevent him or her from being stopped out on market noise and yet protect his or her capital if trend truly regains its momentum.

AUD/USD-3



Trading Considerations

When interpreting price charts when trading Bollinger bands we need to keep the following in mind when making decisions:

• When the bands contract, price is considered more volatile. A price breakout may occur. Likewise, when the bands expand, price is considered less volatile.

• When the price touches or exceeds either the upper or lower bands, an event is signaled, as the price trend generally continues. However, use the event as an indicator only, as price may reverse.

• To determine whether a price reversal is imminent, observe how price behaves following the initial crossing. If the price makes several failed attempts to cross or touch a band again, you may see a price trend reversal.

• If prices break through the upper band, a continuation of the current trend is to be expected.

• If the pikes and hollows outside the band are followed by pikes and hollows inside the band, a reverse of trend may occur.

Trading Bollinger bands helps you monitor and predict price behavior. However, John Bolllinger himself acknowledges that other factors, such as RSI and patterns, should be considered for trading decisions.



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