Trading with Bollinger Bands

This article looks at trading with Bollinger Bands, I use Bollinger Bands as part of my high probability trading setups. I love them as they are simple to use and work on any time frame. As stated in my article 'The Big Guide to Candlestick Patterns', in my opinion a trading “setup” requires multiple characteristics; “If a setup is showing other characteristics such as, Trendline support/resistance, Candlestick pattern formation or other market indicators (i.e. there is a confluence of 'signs')", then this for me gives one a greater advantage of success, thus it indicates the potential for a high probability trade.

So, to put this into context I will explain about Bollinger Bands and how one could trade using this indicator alone. I personally use this indicator in conjunction with Ichimoku and candle patterns to confirm my high probability setups. Make no mistake,this indicator for me is of paramount importance and I could not live without it.

History

Bollinger Bands are a useful and well known technical indicator, invented by John Bollinger back in the 1980s. Bollinger Bands have three lines: an upper, a middle and a lower. They consist of a simple moving average (usually the 20 period SMA) and upper and bottom bands which are placed a number of standard deviations away (usually two). They are thus able to capture 90-95% of a security or indices (can be used on any instrument from Oil, Gold, FX, or Indices) price movements and are the perfect vehicle for measuring volatility. When the two outer bands are far apart (expansion), the stock or index is highly volatile. When the bands are all close together (contraction) volatility is lower. Bollinger Bands are thus the basis for many different trading strategies such as the Bollinger Bands squeeze, the Bollinger Bands breakout, the Bollinger Bands reversal and riding the Bollinger Bands trend. They are also a great indicator for support and resistance levels across multiple timeframes.

Bollinger Bands Parameters

As I mentioned above, the default is to use the 20 Day period simple moving average. The upper band is then placed 2 standard deviations above the 20 SMA and the lower band is placed 2 standard deviations below. Of course, you are allowed to use any parameters you like, but you should remember that if you change the number of standard deviations to say 2.1, the moving average period should change to 50. Likewise, if you change the number of standard deviations to 1.9, the moving average period should change to 10. Bollinger Bands can be used on any timeframe and are useful for pattern recognition or combining with other technical indicators. I like Bollinger Bands a lot, because they are excellent for measuring volatility and they can be overlaid on any time series, not just a stock/index price. Bollinger Bands can be used on volume, open interest, sentiment data.. almost anything. They are therefore very flexible and allow traders a quick way to use standard deviations in their modeling.

Here are my Bollinger Band settings

As I said before, Bollinger Bands are an excellent indicator but only if you use them correctly. The inventor, John Bollinger created a number of rules to guide traders as to how to use them. You can see the full 22 here (to be added). For me the most important rules one should be aware of are below. Rules:

6. Tags of the bands are just that - tags not a signal. 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.

7. In trending markets, price can and does walk up the upper Bollinger Band and down the lower Bollinger Band.

8. Closes outside the Bollinger Bands are initially continuation signals, not reversal signals. (This has been the basis for many successful volatility breakout systems).

19. BandWidth has many uses. Its most popular use is to identify "The Squeeze", but is also useful in identifying trend changes.

20. Bollinger Bands can be used on most financial time series, including equities, indices, foreign exchange, commodities, futures, options and bonds.

21. Bollinger Bands can be used on bars of any length: 1,2,5,10 minutes, one hour, daily, weekly, etc. The key is that the bars must contain enough activity to give a robust picture of the price-formation mechanism at work.

22. Bollinger Bands do not provide continuous advice; rather they help identify setups where the odds may be in your favour.

Rules 20,21 & 22 are obvious. Rules 6,7,8 & 19 explain the possibilities of using Bollinger Bands and are to be taken as 'advisory' on such events occurring.

The Maths

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]

The assumption that the 2 SD bands contain 95% of the data applies only if it is correct to assume a Gaussian (bell curve, Normal) distribution of the data. It is only approximately correct if one assumes the data is unimodal and symmetrical. However, it is true for any data distribution that 2 SD boundaries contain more than 75% of all the data according to Chebychef's Inequality. Furthermore, 3 SD boundaries contain more than 89.9999% and 4 SD more than 93.75%. For the record, in a normal distribution, 1 SD boundaries contain 68% of the data but for an unknown distribution is indeterminate.

See the above bold statement “Furthermore, 3 SD boundaries contain more than 89.9999% and 4 SD contain more than 93.75%” This means that if you are buying or selling at the 3 SD, then you are buying or selling with the knowledge that 90% of people have purchased or sold the security/index at a higher or lower price in any given time frame; 94% if at the 4 SD (Fourth Stand Deviation Band). This is VERY important and I will discuss this later in the conclusion.

Ok now that I have explained the history, parameters, maths and context of Bollinger Bands, you may be somewhat bored! The next paragraph explains trading strategies using the Bollinger Band indicator. These are common strategies and can be found on most trading websites. The last paragraph will detail how I use the Bollinger Band Indicator.

The most common Bollinger Band strategies

Bollinger Band squeeze and breakout band ride.
Trading the trend.
Bollinger Band counter trend.
Playing the bands – trading inside the bands.

Bollinger Band squeeze and breakout band ride

How do you interpret this formation?

The above Dow mini 5 min chart clearly illustrates a squeezing of the Bollinger Bands and then a subsequent expansion and band ride. The price hogs the middle band for 8 candles (40 mins). Actually, it is holding the Ichimoku Kijun-Sen (Blue line) - more on this in another article to come later. After 40 mins, the price breaks out and rides the 2 SD and 3 SD upper bands. It then reverses to find support again at middle band / Kijun- Sen.

Trading squeeze and breakout band ride

Confirm the trend, is it trending up or down? Where do you think the breakout will occur?
Is there a volume spike? Where is RSI? At the top or bottom of the range?
When the price breaks through the upper or lower band, the trader buys or sells the asset, respectively. A stop-loss is traditionally placed outside the consolidation on the opposite side of the breakout.

Bollinger Band trading the trend example 2

The above Dow mini Daily chart again clearly illustrates a squeezing of the Bollinger Bands and then a subsequent expansion and band ride.

The price hogs the lower 2 SD/3 SD bands for 4 days/candles - finding support. Actually, holding the Ichimoku Kijun-Sen (Blue line) - again more on this in another article to come later. The price breaks out and rides the 2 SD and 3 SD upper bands for 7 days. It then reverses at the trend line/2 SD where it finds resistance and drops to find support again at the middle band/Kijun- Sen.

Bollinger Band trading the trend

We have already established the middle line of the Bollinger Bands is simply a 20-period simple moving average (otherwise known as the mean of the Bollinger Bands). In strong trending markets, the 20-period simple moving average can act as an “area of value”.

This means when the market pulls back towards the 20 SMA, it’s an opportunity for you to get long (or short).

The above chart is the weekly Dax chart. You can see that it has been in a long-term uptrend. It found resistance at the trend line and then found support at the middle band and then bounced to the 2 SD upper band (over 1000 ticks in 4 weeks). Notice it also found resistance at the 2 SD (also a double top) and then nosedived!

Bollinger Band counter trend trade

You can see from the above chart how the Bollinger Bands do a pretty good job of describing the support and resistance levels. It's not absolute, but the upper and lower bands do broadly match where the direction reverses. Recognising that this isn't an exact science is a key to understanding Bollinger Bands and their use for counter-trending trades.

Remember rule #6: Tags of the bands are just that, tags not a signal. 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.

This indicator of course was created over 30 years ago. While the #6 rule is true, I can give you thousands of examples where the 2 SD or 3 SD is touched and respected as support or resistance in all timeframes. When the market approaches one of the bands, there is a good chance we will see the direction reverse sometime soon. This, as I stated in the Maths section, is primarily due to the fact that between the 2 SD and 3 SD, one is looking at between 75% to 90% of people having paid a higher or lower price in that timeframe.

A counter-trend trader has to be very careful about risk management. These levels are battlegrounds and eventually prices do breakout of such ranges.

Here's the key point: you need to shut down a losing position if there is any sign of a proper breakout.

Using the same chart as above and as I keep stating time and time again, in my opinion a trading “setup” requires multiple characteristics.

Trading Bollinger Band counter trend trades

Look for a touch of the upper or lower 2 SD or 3 SD – you can use this as a scalp trade, if it is not a break out band ride.
Is there a volume spike? where is RSI? At the top or bottom of the range?
Look for the confluence – are we near a major trend line? Like the above chart.
When the price breaks through the upper or lower band, the trader buys or sells the asset. A stop-loss is traditionally placed outside the consolidation on the opposite side of the breakout.

Playing the bands – trading inside the bands

The above 5 min E-mini chart shows price meandering between upper, middle and lower bands and back again.

Conclusion

The Bollinger Bands indicator can help you identify when the market is “cheap” or “expensive”.
In an uptrend, you can go long near the lower or middle Bollinger Band.
In a downtrend, you can go short near the upper or middle Bollinger Band.
When the Bollinger Bands are in a squeeze, it signals the market is “ready” to breakout.
You can use the 20-period simple moving average to time your entries in trending market.
You can use Bollinger Bands with other trading signal “confluences” to find high probability trades.

As I mentioned in the Maths section. I want to discuss the 3 SD upper and lower Bollinger Bands; “Furthermore, 3 SD boundaries contain more than 89.9999%, and 4 SD more than 93.75%”. This means that if you are buying or selling at the 3 SD (Third Stand Deviation Band) then you are buying or selling with the knowledge that 90% of people have purchased or sold the security/index at a higher or lower price in any given time frame; 94% if at the 4 SD.

These Bollinger Bands in any given timeframe can almost always produce short-term support/resistance to the market. They are perfect opportunities to scalp the market with very little risk, unless price is on an upper or lower band ride. If price is on a band ride then wait for a reversal or Doji candle to confirm a reversal pattern.

I hope you have found this extensive guide to Bollinger Bands useful. Next is Ichimoku Cloud trading! If you have any further questions regarding trading please do not hesitate to contact me. Good luck and happy trading. TI

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