For those of you who’ve followed my Bread & Butter Trader strategy, you’ll know that Bollinger bands are a favourite of mine.
They combine all the simplicity of moving averages with an at-a-glance volatility measure. They are incredibly easy to read and – they work.
However, like all technical indicators, they have weaknesses. But when you understand the weaknesses in your indicator, you know when their signals might be a bit ‘iffy’ and which other indicators would work well to counteract those weaknesses.
Bollinger bands don’t just do one job – they can be used in a number of ways, depending on the type of trading you’re looking for: breakout trades, reversals, or trend-following …
Here I’m going to show you two simple Bollinger band strategies … you can pick the one that best suits your trading …
But before I launch into those, a quick run down on what Bollinger bands are, and how to read them …
How to read Bollinger Bands
Okay, here are your Bollinger band strategy basics …
Bollinger bands are about trend and volatility – they display the price in relation to a standard deviation from the 20-day moving average. When the price is volatile, the bands move apart … when volatility reduces, the bands move closer together.
I like to think of the 20-day moving average as a small stream; the Bollinger bands running either side are like the edge of the flood plain – sometimes the flood plain is wider, sometimes it’s narrow. But when the water (that’s the price bars) get close to the edge of that flood plain – it’s time to sit up and take notice.
We’ll often find prices bumping along, bouncing from the upper Bollinger band to the lower one and back again, like this …
The other things that a Bollinger trader is watching is for a ‘squeeze’ – this is where the bands move closer. This means that volatility has reduced and is a good indication that a breakout could be imminent.
So, those are the basics, but how are we going to build this into a useable strategy?
1. Bollinger Band Strategy: The Volatility Breakout
The first strategy I’m going to look at here focuses on band width as an indicator of when a breakout is likely. Then we watch for a candle to close outside the bands, signalling our breakout.
However … the bands don’t tell us which direction the price is likely to breakout in and it is VERY common for a squeeze to be followed by a false breakout, only for the price to quickly reverse and breakout in the opposite direction.
It’s really important to factor this into your trading – either by adding an extra indicator to help guard against this, or working these losing trades into your risk-reward profile.
You’ll notice on the image above that I’ve added an extra orange Bollinger band – the standard Bollinger band is a deviation of 2 from the moving average – this orange one is set to 1 (half way). It offers a nice tight option for a dynamic stop level on this breakout trade.
So, that’s great when the market is moving, but markets spend most of their time stuck sideways limbo – luckily, Bollinger bands are perfectly suited to those conditions …
2. Bollinger Band Strategy: The Reversal
This is where the Bollinger bounce … bounce … bounce comes in very handy.
As we saw earlier, prices often bounce between the upper and lower Bollinger bands, so, when we hit one of these extremes, we should be looking for a reversal.
And an excellent signal to use on the Bollinger bands is price action – look for reversal candlesticks, like dojis, engulfing or piercing candles. (Check out this post for more info on the most powerful candlesticks LINK)
What we can learn from Bollinger bands – and what we can’t …
Both these strategies are (in my humble opinion) fantastic. But it’s important to remember what Bollinger bands can tell you – and what they can’t.
They’ll give you an indication of overall trend PLUS how far we expect the market to move. Remember, our Bollinger bands are based on moving averages, so they are lagging indicators, meaning that they follow price.
So, how can we know, when we’ve hit a Bollinger band, whether it’s a reversal signal or a breakout signal?
Well, the ‘squeeze’ is a very good indicator of when a breakout is likely. What counts as a squeeze will really depend on the instrument and the timeframe. The best thing you can do is take a look back through old charts and measure past squeezes ahead of breakouts.
The other clues are price action, the strength of the trend, and the addition of an extra indicator.
However, provided you’re careful with the risk-reward profile of trades that you take, you should be able to weather those false moves that catch you out. I strongly recommend that you add Bollinger bands to your charts and see how you get on with them.
And, let me know how you get on …