Bollinger Bands, Volatility And You

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The Basics of Bollinger Bands®

In the 1980s, John Bollinger, a long-time technician of the markets, developed the technique of using a moving average with two trading bands above and below it.   Unlike a percentage calculation from a normal moving average, Bollinger Bands® simply add and subtract a standard deviation calculation.

Standard deviation is a mathematical formula that measures volatility, showing how the stock price can vary from its true value. By measuring price volatility, Bollinger Bands® adjust themselves to market conditions. This is what makes them so handy for traders; they can find almost all of the price data needed between the two bands.

Understanding a Bollinger Band®

Bollinger Bands® consist of a centerline and two price channels (bands) above and below it. The centerline is an exponential moving average; the price channels are the standard deviations of the stock being studied. The bands will expand and contract as the price action of an issue becomes volatile (expansion) or becomes bound into a tight trading pattern (contraction).

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 crisscrossing 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.

Volatility and Bollinger Bands

It is a common knowledge that Bollinger Bands (price standard deviation added to a moving average of the price) are an indicator for volatility. Expanding bands – higher volatility, squeezing bands – lower volatility. A bit of googling and you get the idea. In my opinion – that’s wrong, unless, one uses a twisted definition of volatility.

Let’s consider two possible scenarios:

  • Prices go up 1% for 10 days in a row.
  • Prices go up 1%, down 1% for the same 10 days.

Which one is more volatile in your opinion? What do you think is the conclusion based on Bollinger Bands indicator?

Looking at the figure above, it’s clear that according to our indicator, the volatility is way higher in the first scenario. The figure also reveals the reason – the standard deviation is simply the squared distances from the mean. In the first case, the squares of the large distances over the beginning and the ending of the period add a lot. All in all – exactly the opposite conclusion of what I would have thought – I would prefer my indicator to determine that the volatility is higher in the second case. I can settle for the volatility being approximately the same. But a factor of six is way too much:

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Pretty clear – when prices don’t go too far from the mean (the second case), the bands contract.

The reason for this behavior is that the price series is not stationary:

I am not saying Bollinger bands are useless. They could be used to determine ranging prices (contraction in the bands without significant contraction in the returns). Or to define some extreme profit targets (in strong trends the Bollinger bands widen a lot, thus, taking profits once a widened Bollinger band is touched makes sense). Yes, they are useful, just not for the purpose they are usually advertised for.

The Bollinger Bands Trading Strategy Guide

Last Updated on March 30, 2020

Here’s the thing:

Many new traders think they need more indicators to be a consistently profitable trader.

But the truth is…

It doesn’t work that way.

The price is above the 20 period MA but RSI is showing the market is overbought.

At the same time, the ADX indicator is at 25 which shows a non-trending market.

So, which do you follow?

Now you’re stuck, right?

Well, the good news is…

Bollinger Bands can help you overcome this issue — and much more.

That’s why I’ve created this Bollinger Bands trading strategy guide to show you how useful this indicator is and what it can do for your trading.

Or if you prefer, you can watch this training video below…

Bollinger Bands explained: What is it and how does it work?

Bollinger Bands is a trading indicator (which consist of 3 lines) created by John Bollinger.

It can help you:

  1. Identify potential overbought/oversold areas
  2. Identify the volatility of the markets

Now you’re probably wondering:

“What do the 3 lines mean?”

Upper band – Middle band plus 2 standard deviation

Lower band – Middle band minus 2 standard deviation

Middle band – 20-period Moving Average

Note: I’ve used the default settings for Bollinger Bands which is 20-period moving average and 2 standard deviations for the upper and lower bands.

So, what is standard deviation?

Well, it basically measures how far you’re away from the average.

If you want to learn more, go study this lesson on standard deviation.

So in other words…

If the price is near the upper Bollinger Band, it’s considered “expensive” because it is 2 standard deviation above the average (the 20-period moving average).

And if the is price near the lower Bollinger Band, it’s considered “cheap” because it’s 2 standard deviation below the average.

Here’s an example:

Do not make this MISTAKE when trading Bollinger Bands

Just because the price seems “cheap” or “expensive” doesn’t mean you enter a trade immediately.

Because in trending markets, the market can remain “cheap” or “expensive” for a long period of time.

Here’s an example: EUR/USD remained “expensive” for many months…

As you can see, it’s a painful thing to do if you blindly shorted when the price is at the upper bands.

So what should you do?

Bollinger Bands trading strategy: How to buy low and sell high

You’ve probably heard this a gazillion times.

If you want to make money in the markets, just buy low and sell high.

But the question is… HOW?

Well, you can do so with Bollinger Bands (duh).

The outer Bollinger Bands are 2 standard deviations away from the mean.

This means if the price is in the lower band, it’s considered “cheap”. And if it’s in the upper band, it’s considered “expensive”.

But before you think…

“Great! I’ll just go long when the price reaches the lower band.”

Not so fast my young Padawan.

If you want to have a higher probability of success, then you’ll need a few confluence factors coming together before you trade the bands.

  • Look to long the lower band in an uptrend (and vice versa)
  • Reversal candlestick patterns that show signs of reversal
  • The outer bands coincide with Support and Resistance

Here’s an example:

The price on EUR/USD is at the lower Bollinger Band that coincides with Support, and it formed Bullish Engulfing pattern.

Pro Tip: You can adjust your Bollinger Bands settings to 3 standard deviation (or higher) to identify even more overbought/oversold levels to trade off.

Moving on…

Bollinger Bands Squeeze: How to identify explosive breakout trades about to occur

Volatility is always changing.

The markets move from a period of high volatility to low volatility (and vice versa).

If you’re a new trader, it can be difficult to identify the volatility of the markets.

So, this is where Bollinger Bands can help because it contracts when volatility is low and expands when volatility is high.

Here’s an example:

So, the question is…

How do you use Bollinger Bands to anticipate a possible breakout?

You look for the Bollinger Bands to contract (or squeeze) because it tells you the market is in a low volatility environment.

Because volatility tends to expand after contraction!

An example: Before the breakdown, Crude Oil is in a low volatility environment (as shown by the contraction of the bands).

Pro Tip: The longer the volatility contraction, the stronger the subsequent breakout will be.

How to identify the direction of the breakout

Although Bollinger Bands can alert you to potential breakout trades, it doesn’t tell you the direction of the breakout.

However, you don’t need to be Einstein to figure out where the market is likely to go.

Because all you need to do is look at the trend.

Look at the chart below:

Where do you think the market is likely to breakout, higher or lower?

Probably lower because the trend is down.

And you’re right because the market broke down lower (yes I cherry-picked this chart)…

Simple yet powerful, right?

How to trade with the trend using Bollinger bands

You know the middle line of the Bollinger Bands is simply a 20-period moving average (otherwise known as the mean of the Bollinger Bands).

And in strong trending markets, the 20-period moving average can act as an “area of value”.

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

An example: The price bouncing off the 20-period moving average and it offers shorting opportunities…

Here’s another example:

Pro Tip: If you want to ride the trend, you can trail your stop-loss using the 20 MA, or the outer Bollinger Bands.

The Bollinger Bands and RSI Combo (a little-known technique)

Here’s the thing:

The Bollinger Bands indicator is great for identifying areas of value on your chart.

But the problem is… it doesn’t tell you the strength or weakness behind the move.

For example: How do you tell if the market will continue to trade outside of the outer bands or mean revert?

And what you’re looking for is a divergence on the RSI indicator.

You’re probably wondering:

“What is an RSI divergence?”

Well, it can go 2 ways…

  1. A bearish divergence is when the market makes a higher high, but the RSI indicator shows a lower high (a sign of weakness)
  2. A bullish divergence means is when the market makes a lower low, but the RSI indicator shows a higher low (a sign of strength)

So, now the question is…

“How do you combine RSI divergence with Bollinger Bands?”

If the price is at upper Bollinger Bands, then you can look for a bearish RSI divergence to indicate weakness in the underlying move.

If the price is at lower Bollinger Bands, then you can look for bullish RSI divergence to indicate strength in the underlying move.

Here’s an example:

Pro Tip: You can combine this technique with Support and Resistance to find high probability reversal trades.

The Rubber Band effect: How to use Bollinger Bands and “predict” market reversal

You can think of Bollinger Bands like a rubber band.

Whenever the price gets too far away from it, it tends to mean revert back towards the middle band.

You’re probably thinking…

“But how do you know when it’s about to snap back? Because the price can stay overstretched for a long time.”

You’re absolutely right.

That’s why you must also take into consideration Bollinger Bands, Support Resistance, and Candlestick patterns.

Here’s how it works…

(For long setups)

  1. Look for strong momentum into Support
  2. You want to see the candle close outside the lower Bollinger Bands (this tells you the market is overstretched)
  3. If the next candle is a bullish reversal pattern (like Hammer, Bullish Engulfing, etc.), then the market is likely to reverse higher
  4. And vice versa for short setups

Here’s what I mean…

Price bounced from Support at EUR/CHF Daily:

Price bounced from Support at Brent Crude Oil Weekly:

Pro Tip:

By default, the outer bands are 2 standard deviations away from the middle band (20MA).

If you want to identify even more overstretch market conditions, you can increase the standard deviation to 3 or more.

Frequently asked questions

#1: Hey Rayner, what timeframe does the Bollinger Bands work best on?

There’s really no best timeframe out there to use the Bollinger Bands as the concepts I’ve shared can be applied across different timeframes.

So it depends on your trading style and approach:

  • If you’re a day trader, then you’ll use the Bollinger Bands on the lower timeframe like the 15-minutes or 5-minutes timeframe.
  • If you’re a swing or position trader, then you’ll use the Bollinger Bands on the daily or the weekly timeframe.

#2: Is there any difference between the accumulation stage of a market and a Bollinger Bands squeeze?

Yes, there are differences. An accumulation stage is a range market within a downtrend, where you can identify resistance and support as price swings up and down within the accumulation.

Whereas in a Bollinger Bands squeeze, the market doesn’t swing up and down because the price action gets really tight and the candles are overlapping one another. So it’s impossible to identify support and resistance in a Bollinger Bands squeeze.

#3: Is it better to use Bollinger Bands to trade breakout or to trade market reversals?

It can similarly serve for both breakout and reversal trades.

You can look to trade breakouts after a Bollinger Bands squeeze.

Or you can also use it to trade market reversals after the Bollinger Bands expand, which shows the increase in volatility of the market. If the price comes to a key market structure like support resistance and then forms a price rejection, that’s a possible opportunity for you to take a reversal trade.

Conclusion

Here’s what you’ve learned today:

  • The Bollinger Bands indicator can help you identify when the market is “cheap” or “expensive”
  • In an uptrend, you can long near the lower Bollinger Band
  • In a downtrend, you can short near the upper Bollinger Band
  • When the Bollinger Bands is in a squeeze, it signals the market is “ready” to breakout
  • You can use the 20-period moving average to time your entries in trending market
  • You can use Bollinger Bands and RSI divergence to find high probability reversal trades
  • You can use Bollinger Bands and Support and Resistance to “predict” market reversal

Now, here’s what I would like to know…

How do you use the Bollinger Bands trading indicator?

Let me know your thoughts in the comments section below.

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