Bollinger Bands Explained Video
Check out this quick video on Bollinger Bands before you jump down to the strategies. In the video we will cover a strategiesgies, to familiarize yourself with how the indicator reacts to price action.
Odds are you have landed on this page in search of Bollinger band trading strategies, secrets, best bands to use or my favorite - the art of the bollinger band squeeze. Before you skip down to the section titled bollinger band trading strategies which covers all these topics and more; let me impart two additional resources on the site that are of value to you: (1) Trading Simulator (you will need to practice what you have learned) and (2) Indicators Category (confirming your bollinger band strategy with another indicator is always a plus).
Bollinger Bands Indicator
Bollinger bands are a very powerful technical indicator created by John Bollinger. Some traders will swear that solely trading a bollinger bands strategy is the key to their winning systems. Bollinger bands are drawn within and surrounding the price structure of a stock. It provides relative boundaries of highs and lows. The crux of the bollinger band indicator is based on a moving average that defines the intermediate-term trend of the stock based on the trading time frame you are viewing it on. This trend indicator is known as the middle band. Most stock charting applications use a 20 period moving average for the default bollinger bands settings. The upper and lower bands are then a measure of volatility to the upside and downside. They are calculated as two standard deviations from the middle band.
Bollinger Bands Calculation:
Upper Band = Middle band + 2 standard deviations
Middle Band = 20-period moving average (most charting packages use the simple moving average)
Lower Band = Middle band - 2 standard deviations.
The below chart shows the upper and lower bands for bollinger bands.
Bollinger Band Trading Strategies
Many of you have heard of traditional patterns of technical analysis such as double tops, double bottoms, ascending triangles, symmetrical triangles, head and shoulders top or bottom, etc. The bollinger bands indicator can add that extra bit of firepower to your analysis. They 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. On occasion when trading with 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.
Bollinger Bands Infographic
Before we jump into the strategies, take a look at the 15 things you should know about bollinger bands. This will help ground you with some guidelines when using the indicator, which will help you understand the more advanced techniques detailed later in this article.
#1 Strategy - Double Bottoms and Bollinger Bands
A common bollinger band strategy 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.
Below is an example of the double bottom outside of the lower band which generates an automatic rally. The setup in question was for FSLR from June 30, 2011. The stock hit a new low with a 40% drop in traffic from the last swing low. To top things off, the candlestick struggled to close outside of the bands. This led to a sharp 12% rally over the next two days.
#2 Strategy - Reversals with Bollinger Bands
Another simple yet effective trading method is fading stocks when they go outside of the bands. Now, take that one step further and apply a little candlestick analysis to this strategy. For example, instead of shorting a stock as it gaps up through its upper band limit, wait to see how that stock performs. If the stock gaps up and then closes near its low and is still completely outside of the bollinger bands, this is often a good indicator that the stock will correct on the near-term. You can then take a short position with three target exit areas: (1) upper band, (2) middle band or (3) lower band. In the below chart example, the Direxion Daily Small Cap Bull 3x Shares (TNA) from June 29, 2011 had a nice gap in the morning outside of the bands, but closed 1 penny off the low. As you can see in the chart, the candlestick looked terrible. The stock quickly rolled and took an almost 2% dive in under 30 minutes, proving very profitable for any day trader.
#3 Strategy - Riding the Bands
The single biggest mistake that many bollinger band novices' make is that they sell the stock when the price touches the upper band or conversely buy when it touches the lower band. Bollinger himself stated that a touch of the upper band or lower band itself does not constitute a bollinger band signals of buy or sell. Not only have I seen, but I have also traded this bollinger band strategy as a continuation trade. Using other technical indicators and chart 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 and to my point above, 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.
I want to touch on the middle band again. 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, 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 ride the Bollinger bands.
#4 Strategy - Bollinger Band Squeeze
Another bollinger bands trading strategy is to gauge the initiation of an upcoming squeeze. He created an indicator known as the band width. This bollinger band width formula is simply (Upper Bollinger Band Value - Lower Bollinger Band Value) / Middle Bollinger Band Value (Simple moving average). The idea, using daily charts, is that when the indicator reaches its lowest level in 6 months, you can expect the volatility to increase. This goes back to the tightening of the bands that I mentioned above. This type of squeezing action of the bollinger band indicator foreshadows a big move. You can use additional indicators 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.
We need to have an edge though when trading a bollinger band squeeze, because these types of setups can head-fake the best of us. Notice above in the BSC chart how the bollinger price expanded on the opening of 9/26. It immediately reversed and all the breakout traders were head faked. You don't have to squeeze every penny out of a trade. Wait for some confirmation of the breakout and then go with it. If you are right, it will go much further in your direction. Notice how the price and volume broke when approaching the head fake highs (yellow line).
To the point of waiting for confirmation, let's take a look of how to use the power of a bollinger band squeeze to our advantage. Below is a 5-minute chart of Research in Motion Limited (RIMM) from June 17, 2011. Notice how leading up to the morning gap the bands were extremely tight.
Now some traders can take the basic trading approach of shorting the stock on the open with the assumption that the amount of energy developed during the tightness of the bands will carry the stock much lower. Another approach is to wait for confirmation of this belief. So, the way to handle this sort of setup is to (1) wait for the candlestick to come back inside of the bollinger bands and (2) make sure there are a few inside bars that do not break the low of the first bar and (3) short on the break of the low of the first candlestick. Based on reading these three requirements you can imagine this does not happen very often in the market, but when it does it's something else. The below chart depicts this approach.
Now let's take a look at the same sort of setup, but on the long side. Below is a snapshot of Google from April 26, 2011. Notice how GOOG gapped up over the upper band on the open, had a small retracement back inside of the bands, then later exceeded the high of the first candlestick. These sort of setups can really prove powerful if they end up riding the bands.
#5 Strategy - Snap Back to the Middle of the Bands
This strategy is for those of us that like to ask for very little from the markets. Essentially you are waiting on the market to bounce off the bands back to the middle of the bands.
What I like about this strategy is that you will bat a high winning percentage over time. You are not obsessed with getting in a position and it wildly swinging in your favor.
Nor are you looking to be a prophet's of sorts and try to predict how far a stock should or should not run.
By not asking for much, you will be able to safely pull money out of the market on a consistent basis and ultimately reduce the wild fluctuations of your account balance which is common for accounts that take big risks.
The key to this strategy is waiting on a test of the mid-line before entering the position. You can increase your likelihood of placing a winning trade if you go in the direction of the primary trend and there is a sizeable amount of volatility.
As you can see in the above example, notice how the stock had a sharp run-up, only to pull back to the midline. You would want to enter the position after the failed attempt to break to the downside.
You can then sell the position on a test of the upper band. If you have more of an appetite for risk, you can ride the bands to determine where to exit the position.
#6 Strategy - Trade Inside the Bands
This is honestly my favorite of the strategies. If I gave you any other indication that I preferred one of the other signals, forget whatever it is I said earlier.
The majority of the money to be made in the market, with minimal risk is in the margins.
The same way we say football is a game of inches, trading is the same.
You, of course, can make a ton of money placing big bets, but these types of traders do not make it over a long trading career (20+ years).
First, you need to find a stock that is stuck in a trading range. The greater the range the better.
Now, looking at this chart, I feel a sense of boredom coming over me. That's because it's far more entertaining to tell yourself and others you crushed a 20% day trade in one day.
However, from my experience, the guys that take money out of the market when it presents itself, are the ones sitting with a big pile of cash at the end of the day.
In the above example, you simply buy when a stock tests the low end of its range and the lower band. Conversely, you sell when the stock tests the high of the range and the upper band.
The key to this strategy is a stock having a clearly defined trading range. This way you are not just trading the bands blindly, but are using the bands as a means to gauge when a stock has gone too far.
You could argue that you don't need the bands to execute to this strategy. However, by having the bands, you can validate that a security is actually in a flat or low volatility phase, by reviewing the look and feel of the bands.
A simpler way of saying this, is that the bands help validate that the stock is stuck.
So, instead of trying to win big, you just play the range and collect all your pennies on each swing of the stock.
Which Strategy Works Best?
This is the obvious question for anyone reading this article. You want to know if you had to pick just one strategy, which one is the best?
For me, it's strategy number 6 hands down, because you are constantly taking money out of the market and it has a high winning percentage.
How do I know it has a high winning percentage?
Because you are not asking much from the market in terms of movement. From my personal experience of placing thousands of trades, the more profit you search for in the market, the less likely you will be right.
Now, strategy 6 works best for me, but what about the rest of you. Since trading is a personal journey, some of the other approaches may work best for your risk profile.
Below is a quick list of the trading styles and which ones are best aligned to the six strategies covered in this article:
- Strategy #1 Double Bottoms - this is for the true technician. The trader that is going to scan the entire market looking for a specific setup. This will require a ton of patience to identify the setup since you really need the second bottom to breach the bands to generate a powerful buy signal.
- Strategy #2 Reversals - calling all of my risk takers. This strategy is amazing when you get it right because the reversal is so sharp, money will pour into your account. However, get things wrong and the pain can often leave you paralyzed from taking any action. You have to be quick on your toes and willing to cut a loser without blinking.
- Strategy #3 Riding the Bands - this is for all my home run hitters out there. You must have the sheer will to only average a 20% to 30% win ratio because you will make all of your money on the big moves. That sounds easy, doesn't it? Well, I have tried systems that have low win percentages and I have failed every time. This is because I am a sore loser. Therefore, I can't handle being wrong that frequently. So, if you want to take less action and can seriously handle being wrong eight out of ten times, this system will be great for you.
- Strategy #4 The Squeeze - this for me is the best setup for the traders that want the profit potential of riding the bands, but are able to take quick money as things go in your favor. You can take one of two approaches with the squeeze strategy. For the riskier traders, you can jump in before the break and capture all of the gains, but risk things going the other way. More conservative traders can wait for the break and then look for a setup in the direction of the trend.
- Strategy #5 Playing the Moving Average - this strategy is for all of the pullback traders. You are looking for stocks that are trending strongly and then have a reaction back to the 20 period moving average. This setup works lovely when day trading the Nikkei and usually develops a little after forty-five minutes into the session.
- Strategy #6 Trading the Range - I think I have already praised this one enough. For me it comes down to the simple fact markets are range bound 80% of the time. So, if you need thrills, this strategy will put you to sleep. You will likely want to focus on #2, #3, or #4.
What to Do When the Bands Fail?
Like anything else in the market, there are no guarantees. Bollinger bands can be a great tool for identifying volatility ni a security, but it can also prove to be a nightmare when it comes to newbie traders. Don't skip ahead, but I will touch on this from my personal experience a little later in this article.
Like any other trade signal, you will need to exit your position without reservation.
Not exiting your trade can almost prove disastrous as three of the aforementioned strategies are trying to capture the benefits of a volatility spike.
For example, imagine you are short a stock that reverses back to the highs and begins riding the bands. What would you do?
Let me help you out if you are confused - kill the trade!
While bands do a great job of encapsulating price movement, it only takes one extremely volatile stock to show you the bands are nothing more than man's failed attempt to control the uncontrollable.
In addition, to strategies, there are a few items related to bollinger bands I need to cover that will provide you with a full picture of the indicator. These are not hard fast rules, but things you need to consider as you validate if the indicator is a good fit for you and your trading style.
What are the Ideal Bollinger Bands Settings?
Regardless of the trading platform, you will likely see a settings window similar to the following when logging into the application.
If you are new to trading, you are going to lose money at some point. This process of losing money often leads to over-analysis. While technical analysis affords us the ability to identify things unseen on a ticker, it can also aid in our demise.One of the unfortunate
In the old times, there was little to analyze. Therefore, you could tweak your system to a degree, but not in the way we can constantly tweak and refine our trading approach today.One of the unfortunate
Case in point, the settings of the bollinger bands indicator. While the configuration is far simpler than the many other indicators, it still provides you the ability to run unlimited optimization tests to try and squeeze out the last bit of juice from the stock.
The problem with this approach is after you change the length to 19.9 (yes people will go to decimals), 35 and back down to 20; it still comes down to your ability to manage your money and book a profit.
My strong advice to you is to not tweak the settings at all. It's actually better to stick with 20, as this is the setting all the traders are using anyways to make their decisions.
I always like to know what's coming at me versus trying to look for some secret setting that does not exist.
Introducing Bollinger Bands Width
Pairing the bollinger band width indicator with bollinger bands is like combining the perfect red wine/meat combo you can find.
I'm not going to go into too much detail on bollinger band width, but the key takeaway is that you get all of the analysis you would like, without turning into a hermit in your basement running thousands of calculations.
In the previous section, we talked about staying away from changing the settings. Well, if you really think about it, your entire reasoning for changing the settings in the first place is in hopes of identifying how a specific security is likely to move based on its volatility.
A much easier way of doing this is to use the bollinger bands width. In short the the bb width indicator measures the spread of the bands to the moving average to gauge the volatility of a stock.
Why is this important to you?
Well, now you have an actual reading of the volatility of a security, which you can then use to look back over months or years to see if there is any repeatable pattern of how price reacts when it hits these extremes.
Still don't believe me? Take a look at the below screenshot using both the bollinger bands and bollinger band width.
Notice how the bollinger band width tested the .0087 level three times. The other point of note is that on each prior test, the high of the indicator made a new high, which implied the volatility was expanding after each quiet period.
As a trader, you need to separate the idea of a low reading with the bollinger bands width indicator with the decrease in price.
Remember, bollinger band width are informing you that a pending move is coming, the direction and strength are up to the market.
In this example, Sciclone Pharmaceuticals (SCLN) had a huge runup from $9.75 to 11.12.
Did I fail to mention this is a 5-minute chart of SCLN?
Notice if you just looked at the bollinger bands, it would be nearly impossible to know that a pending move was coming. You would have no way of knowing that .0087 was a level that existed, let alone a level that could trigger some sort of price action.
This is just another example of why it's important to pair bollinger bands with other indicators and not use it as a standalone tool.
My Personal Experience with Bollinger Bands
I think it's safe to say Bollinger Bands is probably one of the most popular technical indicators in any trading platform
If my memory serves me correctly, bollinger bands. moving averages and volume were likely my first taste of the life.
Well as of today, I no longer use bollinger bands in my trading. That doesn't mean that they can't work for you, I just found that my trading style requires me to use a clean chart.
So, how did I end up abandoning the bands? Well, let me dig a little deeper so you can understand my rationale.
I tend to over analyze setups; it's what I do.
Therefore, the more signals I have on a chart, the more likely I am to feel the need to take some sort of action in response to said signal. This is where the bollinger bands expose my trading flaw.
For example, if a stock explodes above the bands, what do you think is running through my mind? You guessed right, sell!
In reality, the stock could just be starting it's glorious move to the heavens, but I am unable to mentally handle the move because all I could think about was the stock needed to come back inside of the bands.
Day Trading in 2007
Flashback to 2007 when I was just starting out in day trading; I literally had no idea what I was doing.
Instead of taking the time to practice, I was determined to turn a profit immediately and was just trying different ideas.
One of the first ideas I put to the test was bollinger bands.
Why? It's one of the most popular indicators.
I decided to scalp trade and I would sell every time the price hit the top bands and buy when it hit the lower band. I know, don't judge me, it's pretty bad.
From what I remember, I tried this technique for about a week and at the end of this test, I had made Tradestation rich with commission costs.
The key flaw in my approach is that I did not combine bollinger bands with any other indicator. This left me putting on so many trades in a day that at the end of my head was spinning.
What it Takes to Trade with Bollinger Bands
I think to really harness the power of bollinger bands, you need to learn how the bands interact with price. At the end of the day, bollinger bands are a means for measuring volatility. So, it's not something you can just pick up and use for buy and sell signals.
Just as you need to learn specific price patterns, you also need to learn how bollinger bands respond to certain price movements.
This ability to identify the setups will help you avoid the fake signals from the real ones.
This level of mastery only comes from placing hundreds if not thousands of trades with the same markets on the same time frame.
Bollinger Bands in the Trading Community
I went onto Amazon to search for the most popular books in order to see who the leaders are in the space.
No surprise, John Bollinger had the most popular book - "Bollinger on Bollinger Bands".
The thing that surprised me is that I couldn't find many other popular authors or experts in the space. I'm not sure if this is because there aren't many people interested or if other traders stay out of the bollinger bands space because John is still so actively evangelizing the bands.
The books I did find were written by "basement authors" and honestly have less material than what I have composed in this article. The other hint that made me think these authors were not legit, is their lack of the registered trademark symbol after the bollinger bands title, which is required by John for anything published related to bollinger bands.
However, when I search on Elliott Wave, I find a host of books and studies both on the web and in the Amazon store.
I am still unsure what this means exactly. With there being million of retail traders in the world, I have to believe there are a few that are crushing the market using bollinger bands.
I just struggled to find any real thought leaders outside of John. I write this not to discredit or credit trading with bands, just to inform you the reader of how bollinger bands are perceived in the trading community.
Best Time Frames for Trading with Bollinger Bands
Bollinger bands work well on all time frames. Remember, price action performs the same, just the scales of the move are different.
What are the Best Markets for Bollinger Bands?
Without a doubt the best market for bollinger bands is Forex. I say this because currencies tend to move in a methodical fashion allowing you to really measure the bands and size up the trade effectively.
Next, I would rank futures because again you can begin to master the movement of a specific contract.
Last on the list would be equities. The captain obvious reason for this one is due to the unlimited trading opportunities you have at your fingertips at any given moment.
It's one thing to know how the e-mini contract will respond to the lower band while in a five-day trading range.
It's an entirely different story to have to size up one stock from the next in terms of how well a given security responds to the bands. There will be some stocks that simply do not care and do whatever the want.
You will need to be able to determine when to pull the trigger and when to pass.
These are a few of the great methods for trading bollinger bands. I am not one to use many indicators on my charts due to the cluttered feeling I get. I keep price, volume, and bollinger bands on the chart. Keep it simple. If you feel the need to add additional indicators to confirm your analysis, make sure to test it out thoroughly in advance to putting any trades on.
The key point again is bollinger bands gets you in the habit of thinking about volatility. There are so many traders looking for some percentage profit on a trade, when the stock hasn't moved that amount in over ten years.
You will need to do the following in order to really take your bollinger bands trading to the next level:
- Settle on a market you want to master (i.e. futures, equities, forex). If you try to learn all three at the same time, you are headed down a painful road.
- Figure out what time frame works best for you.
- Learn to master one strategy before attempting to tackle them all. Any of the strategies mentioned in this article can work given the right market environment and your willingness to stick to your trading plan. However, similar to points one and two above, learn how to focus on getting one thing right before you complicate matters.
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