EXPERTS EXPLAIN: ADVANCED TRADING TIPS
How to form a Bollinger Band Trading Strategy
Introduced by John Bollinger in the early 1980s, Bollinger Bands are one of the most popular technical indicators for both discretionary and mechanical traders. Discretionary traders use their experience to evaluate market conditions to decide when to enter and exit trades. Systematic traders, also known as mechanical or algorithmic traders, use fixed rules to determine when they enter and exit trades.
Bollinger Bands are easy to use and adapt to every market and timeframe. Whether you are a new trader or seasoned professional, Bollinger Bands could make a big difference to your trading results.
What are Bollinger Bands?
In the early 1980s, John Bollinger was searching for a way to improve the existing trading bands. He realised that the bands that were available at the time such as, Price (Donchian) Channels and Keltner Channels, did not do a good job of fitting price data.
His research led him to create Bollinger Bands that expand and contract so that they always contain most of the price action. Bollinger Bands are easy to calculate; the centre line is a 20-period simple moving average (SMA). The SMA is the mean average or sum of the closing prices divided by the number of periods. The upper and lower Bollinger Bands are then offset by two times the standard deviation. The standard deviation is a measure of volatility that calculates how spread out the data is. Approximately 95% of the previous close prices will be within the bands.
Example Bollinger Bands Strategy 1 – Determine Overbought/Oversold Levels
Any time the price is trading above the upper band, it is overbought relative to recent price action. When the price is trading below the lower band, it is oversold. One of the most popular ways to trade overbought/oversold levels is to use a moving average to identify the dominant trend on a higher timeframe. Then drop down to a lower timeframe and use Bollinger Bands to identify trade entry points in the direction of the trend.
The chart below shows Amazon Inc. with the moving average in an uptrend on the daily chart. The 60-minute chart provides several buy entry points when the price is below the lower band. Note that even though the price is often above the upper band, it is usually wiser to stick with the trend, and wait until you get another buying opportunity below the lower band.
What these insights can mean for traders
Markets frequently switch from trending to mean reversion. Trending markets go in one direction for an extended period. Mean reversion is when markets pull back from an overbought or oversold level and return to a previous price. You can take advantage of both factors by trading in the direction of the dominant trend when the price is overbought or oversold on the lower timeframe.
Example Bollinger Bands Strategy 2 – The Bollinger Squeeze
John Bollinger says that “new trends are born when Bollinger Bands constrict.” Volatility may be the most reliable cyclical factor in the financial markets. Prices regularly move from high volatility to low volatility and back again. You can use this knowledge to develop high reward/risk trades - when your potential profit is larger than your potential risk.
A classic way to identify high reward/risk trades is using the Bollinger Squeeze. The EUR/USD chart below shows two excellent squeeze opportunities. A squeeze occurs when volatility declines and the bands constrict.
To follow this strategy, you should enter long trades when the price breaks above the upper Bollinger Band, and short trades when the price drops below the lower band.
What these insights can mean for traders
The beauty of Bollinger Squeeze trades is they put mathematics on your side. Traders who understand and regularly employ the indicator believe it can help with consistency. Used correctly and with discipline, it can boost profitable trades while helping to limit losses when prices move unexpectedly.
The Bollinger Bandwidth Indicator
Bollinger Bandwidth is a separate indicator that measures the width of the Bollinger bands.
Bollinger Bandwidth makes it easy to identify new lows and highs visually. This is useful in the Bollinger Squeeze trade (described above). Whenever the Bollinger Bandwidth is at a significant low, there is a good chance for a Bollinger Squeeze trade. In July 2020, Bollinger Bandwidth for Bitcoin hit a new 18 month low, setting the stage for a 20% rally. The weekly Gold chart below shows how Bollinger Bandwidth narrowed three times before rallying to an all time high in July 2020.
Use the Bands to Time Your Exits
Most traders focus on trade entries; waiting for the perfect moment to buy or sell. However, you make your profit or loss when you exit a trade. Exits are often harder to get right than entries. This is because whenever you have a trade in the market, you are anxious and want it to do well. Some traders consistently close trades too early, snatching at any small profit. Others tend to hold on to bad trades too long and end up nursing a big loss.
A good trading rule is to make your exits as simple and easy as possible. Bollinger Band strength exits allow you to close a trade when it is performing well. Traders who follow this rule will exit long trades when the price closes above the upper band, and exit short trades when the prices closes below the lower band.
The chart below shows the US 500 on the 4-hour timeframe. Each time the price closes above the upper Bollinger Band provides a good potential exit point for long trades.
Bollinger Bands are a simple but powerful indicator that can help you make better trading decisions.
Mark Ursell – Tradinformed.com