Bollinger Bands Trading

Bollinger Band Definition

Bollinger Bands are a very powerful technical indicator. Many traders develop trading systems strictly around trading this indicator. 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 indicator is based on a moving average that defines the intermediate term trend of the stock based on the trading timeframe you are viewing it on. This trend indicator is known as the middle band. Most stock charting applications default the middle band to a 20 period moving average. 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.

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.

Practical Use of Bollinger Bands

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. Bollinger bands 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, you will see the Bollinger bands coiling very tightly which can indicate that the stock is trading in a very 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 almost the calm before the storm.

A common and basic technique for using the Bollinger bands 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.

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 often states that a touch of the upper band or lower band itself does not constitute a buy or sell signal. Not only have I seen, but I have also traded this setup as a continuation trade. Using other technical indicators and 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.

Bollinger Bands

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 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.

Bollinger Band Squeezes'

Bollinger developed a great way to gauge the initiation of an upcoming squeeze. He created an indicator known as the Band width. This 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 in the Bollinger bands 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 to the case you are trying to present.

We need to have an edge though when trading these types of setups as they can head-fake the best of us. Notice above in the BSC chart how the 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).

Conclusion

These are a few of the great ways to employ Bollinger bands in your trading techniques. 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.