On our previous post we learned about the importance of understanding the Standard Deviation indicator and how it can be used to spot ranges and trends as well as momentum or trend fuel.
Bollinger Bands are a very popular indicator / trading system that is entirely based on the premises of Standard Deviation.
As you see below, the Bollinger Bands indicator is composed of:
- A middle line which is usually a Simple Moving Average of Price
- A line above which is calculated by adding a multiplier of the Standard Deviation, usually 2x, to the Moving Average line
- A line below which is calculated by subtracting a multiplier of the Standard Deviation, usually 2x, to the Moving Average line
By looking at the chart above we can determine that price was ranging 2x deviations above and below the average when the Standard Deviation indicator was at low levels.
As the Price broke pass the the top Bollinger band (2 x Standard Deviation), the Standard Deviation indicator also began to increase and both simultaneously continued their trend upward until price returned back to the mean (average) and began to move again within a range of 2x deviations
Bollinger Bands Strategies
- Bollinger Breakout: Enter trades at the break of the top or bottom Bollinger Band, ONLY when previously followed by a period when price was ranging within the two bands and/or when the Standard Deviation level was visually low compared to past values. An exit can be determined, in this case, when price closes below the top band or when prices return to the average.
- Bollinger Bounce: When periods where price is trending sideways, as seen below, represented by low levels of Standard Deviation or a somewhat horizontal Bollinger Band structure, the top and lower bands serve as support and resistance. Entering trades at the top or bottom almost always follows price returning at least to the average, if not to the other extreme.
Advance Bollinger Band Strategies
Personally I prefer to use a system of 3 Bollinger Bands. Some indicators come already with multiple bands. In the case below I simply attached 3 Bollinger Bands indicators, each with 1, 2 & 3 deviations from the mean. The reasoning will become more clear when we talk about the Theory of Normal Distribution
- Trend Continuation: Most often than not, after price breaks the second Bollinger band, price will continue moving in that direction until price crosses to the opposite side of the mean (middle red line) at which time you should exit the trade. However if price crosses back again towards the previous trend direction then you have a Continuation Entry. You will exit the trade at the next crossing with the mean. A slightly riskier entry would be when price reverts back to the first band (blue). In this case I would still prefer to wait for it crossing over the first band and entering when it crosses back below.
- Bollinger Stop: Another strategy I am a fan of is the Bollinger stop. In this case we enter trades in the direction of the break of the second band, but instead of exiting at the cross with the mean, we place a trailing stop at the 2 band opposite to the mean. In the image below the second band is represented with a white line and the arrow on the left represents your entry while the other two on the right represent when your position would most likely been close represented by a touched of the opposite white line. It is worth noting that this strategy has a stop loss that equals 4 x Standard Deviation thus position size should be adjusted to not over position yourself in case if you get stopped out before profits are made.