When it comes to technical trading, few people have an impact big enough for their name to become part of the lexicon of the industry, but John Bollinger is one such person. A long-time market technician, John Bollinger started looking at new ways of determining trading bands, that is areas of support and resistance, through adaptation of moving averages in the early 1980s. Information was hard to find in those pre-internet days, but using a basic microcomputer, John began developing his own approach.
Building on previous works such as the Keltner Bands, Bollinger realized that percentage-based bands do not adapt well to changing market positions due to their fixed nature, with later developments using other ways to change the response, such as basing percentages on recent highs and lows rather than averages. However, Bollinger understood that this was a compromise and that percentage-based bands needed constant adjustment to keep them relevant to the current market conditions.
To combat this, John Bollinger began using standard deviations to overcome the static nature of percentage-based bands, and this change, which effectively brought an allowance for volatility into the calculation, is the reason that the bands stood out and were viewed as a completely unique approach. But how did they become known as Bollinger Bands? John himself says that came after he was asked live on air in a radio interview what he called these new bands, and without any prepared answer, just said his own name.
Trading Bollinger Bands: What are they and how are they created?
The defining characteristic of the Bollinger Bands is the use of standard deviations to represent changing volatility, but what does that mean in practice?
The Bollinger Bands consist of three lines as follows:
- The Middle (Basis) Bollinger Band– This is a simple moving average of price, usually set to a 20-day timeframe, although that is a variable that can be adjusted any time.
- The Upper Bollinger Band– This line takes the 20-day simple moving average of the Middle Band, and then adds 2 standard deviations of that value.
- The Lower Bollinger Band– This line takes the 20-day simple moving average of the Middle Band, and then subtracts 2 standard deviations of that value.
The two variables here are the timeframe for the moving average and standard deviation away from that average. In our examples, these are 20-day averages and a standard deviation of 2. When using the bands, this would be described as Bollinger bands (20,2,2). While those are the standard numbers used by traders, both can be varied within the chart software you use. Obviously, changing the simple moving average period does not just change the middle band, it also affects the upper and lower that are based off its values, experimenting with values here can change the responsiveness of the upper and lower Bollinger Bands, which can be useful in particularly volatile markets.
The standard deviation value specifically changes the width of the bands, that is how far away the lower and upper Bollinger Band are from the middle band’s simple moving average. In other words, the larger the value, the larger the width between the upper and lower Bollinger Band. This matters when trading, if the bands are too wide, the market may never move enough to touch the band in either direction, so while you can change it from the standard value of 2, be wary of going too far.
Likewise, having the standard deviation value too close to the average (less than 2) can lead to a lot of false signals as the market hits the bands repeatedly due to a smaller width. If you are just starting out with Bollinger Bands, using the standard values allows you to get a good feel for how they work, and after that, experiment a little to refine things to work the way you like as well as following what the current stock you are looking at fits best with (i.e. if a stock is extremely volatile, it may be good to expand to 2.5 or 3 standard deviations).
While all that covers how Bollinger bands are calculated, and how changing variables can alter how they interact with market prices, it is also important to understand what the lower and upper Bollinger Band represent. The two bands move with the simple moving average of price, and the gap between the upper and lower Bollinger band widens or narrows as volatility grows or shrinks.
The Upper Bollinger Band represents the area in which price is nearing two standard deviations above the average and is commonly an area at which the price reaches resistance and tends to retreat to its simple moving average. For the Lower Bollinger Band, it represents the area in which price is nearing two standard deviations below the average and is commonly a technical area where the market finds support level (unless there is a large fundamental change in the company in which these levels become irrelevant).
Therefore, with Bollinger Bands, we can identify reversals as well as trend breakouts very clearly, but how do we use that information in practice?
Trading Bollinger Bands: Different Strategies
It’s nice to know how these indicators work, but as a trader, what you really want to know is how to use Bollinger Bands to make money. While some indicators or chart patterns only show a single trade set-up, Bollinger bands are quite flexible, and there are several ways to use the information that they provide to trade successfully. We are going to look at the three most common uses of Bollinger Bands when trading, and also explain how you can make successful trades by following these strategies.
1. Lower Band Bounces
Because Bollinger bands set out to indicate the high and low range of a stock or other instrument, one of the most common ways to trade it is to wait until the market price reaches the lower Bollinger Band and look for a reversal to the simple moving average above (generally a candle reversal or lower indicator divergence). The reasoning behind it is simple; if the Lower Bollinger band indicates the support level, that is likely where technical traders will come back in for a quick scalp.
In practice, it is easy to get this wrong which is why you will see trade forums full of people telling you Bollinger bands don’t work. It is tempting to think that once that lower band is hit, you should just buy the stock and wait for it to go up again. However, as anyone who has traded for any length of time will tell you, always wait for confirmation.
Trends do not last forever, so sometimes, if a price cuts through the lower band, it can just keep breaking down. Buying when the market is going down like that is one way to potentially lose quickly. To avoid this simple mistake, look for the market to change direction before buying in. That means watching the candle formation for a potential reversal (to freshen your memory on candlestick formations, make sure to check out our Candlestick 101 blog post).
There is something else to discuss in this strategy that is often left out when talking about trading methods, and that is when to exit. So much attention is paid to the entry point for a trade, that the exit just seems to be taken for granted even though it is the most important part. A good exit strategy is a key to continued success and without it, traders tend to either take profits too early and leave money behind. See figure 6 above for a trading strategy in which involves trading the lower Bollinger Band once it reverses to the SMA and then scaling out on the way up to the upper Bollinger Band.
2. Upper Band Pullbacks
As the lower Bollinger Band represents the lower price range in which the price is likely to trade within, the upper Band represents the higher range the price is likely to meet resistance and turn back towards the simple moving average.
These bounces work in exactly the same way as the lower band bounce, except you are taking a position for the price to retreat down to the simple moving average line after it breaks the upper band (i.e shorting or buying puts). Again, entry means waiting to confirm the direction, so a candle after the signal with a lower low and a lower close than the signal candle.
As with the lower bounce, the target for the trade is the simple moving average line as your exit signal.
3. Breakouts/Breakdowns
The final commonly-used Bollinger Band trading strategy is one that looks at the current range of trading, that is the support and resistance levels that the Bollinger bands represent, and trades on signals that the market is breaking out of that particular range. This is a popular strategy for several reasons, but one of the main ones is that if a ticker has been trading inside a range for a while, when it does break out, the move can be very big and give traders a lot of profit.
The breakout trade works best in a market where the price has repeatedly hit the upper or lower Bollinger Band over an extended period without moving out of the range completely. This is a signal for a larger move, and the idea behind the strategy is to buy if the market breaks beyond the upper Bollinger Band, which is the resistance level for the range, or, sell the market of it breaks through the lower Bollinger Band, which is the support level.
As with the bounce strategy, the key to getting this right is confirming the market direction before getting into a trade, avoiding false signals. For breakouts through the upper Bollinger Band, the signal to buy is the next candle that has a higher high, and closes higher, than the signal candle (see image above). For breakouts downwards through the support levels, that is the Lower Bollinger Band, the entry signal to sell the market is a candle with a lower low and a lower close than the signal candle.
In this instance, the exit strategy is not so clear-cut, breakouts can run and run sometimes, or be over after just a short move, and you never know which. Many traders look for a sign of a market turn, three candles in the opposite direction is a common approach for an exit. For others, if the trading platform supports it, an automatic stop-loss set at a suitable range is a ‘set and forget’ way to exit the trade. Which method you choose will depend on your general trading approach.
Trading Bollinger Bands: Multiple Time Frames
Bollinger bands, as we have seen, are great for showing support and resistance and enabling traders to have easy-to-use, accurate strategies for identifying market reversals and breakouts. However, as with any kind of trading, looking beyond a single chart is a great way to add more insight into trading and make even more educated decisions. This is especially true of Bollinger Bands, where the different simple moving averages of different time frames can really show a clearer picture of what is going on with any market.
With Bollinger Bands, we are trading normal curves in each time frame, but by varying standard deviations across different time frames we can get a more detailed look at market direction, enhancing the normal curve with additional viewpoints. Trend Spider allows us to plot multiple Bollinger time frames on a single chart, so we can see the Bollinger bands for a longer timeframe while looking at shorter ones, always giving us a more detailed look at any market. This, in turn, allows confirmation of trade entries, for a reversal or a breakout, with increased accuracy. Trading on a 4-hour chart and seeing for instance the 1-hour Bollinger Bands can help establish direction changes much more quickly.
Of course, each time frame is also suited to a particular style of trading, and Bollinger bands are adaptable enough to be extremely useful whichever time frame they are used in. If you were day trading a specific instrument, then the shorter, 1-hour or even 5-minute or less charts have the intraday detail needed to make those fast, snappy trades that day traders love. However, for swing traders, the lower time frame charts are just noise, they need much longer daily or weekly charts to see the overall picture of the trends they follow.
In each case, Bollinger Bands are incredibly useful, and provide the same support and resistance visuals that can be the basis of a trading strategy on their own. Whether you choose one or two specific time frames or use a quality trading tool like Trend Spider to use multiple-time frame analysis on a single chart, Bollinger Bands provide the at-a-glance information you need to succeed.
The Self-Fulfilling Prophecy
One aspect of Bollinger Band trading that we need to think about just how popular this indicator is with algorithmic trading software. In fact, it is a major part of many hedge fund trading strategies, which is why today Bollinger Band signals actually become a self-fulfilling prophecy.
Hedge funds control billions of dollars in investments. As they use algorithmic trading software that often focuses on Bollinger bands, think about what happens when the market hits a Band level. If it hits the upper Bollinger band, then as per the hedge fund trading strategies, automatic sell orders will be placed in anticipation of the market turning back down to the simple moving average.
But this is not like you or I simply making a trade, this is hundreds of hedge funds and other large investors selling millions of shares of a given stock at once. This added supply pushes down in any market no matter how liquid it is, which is exactly what they are looking for. So, the price drops because big money is selling, which obviously works for their position, but is it really the Bollinger Band causing it?
The price goes down because they all sell, but they sell because the Bollinger Band indicated the price would go down. Whatever the cause, the effect is the same, if you are short at that particular area, you make money. Of course, the same principle applies for the market-hitting support and the algorithmic trading software all start buying the stock at the same time causing supply to outpace demand.
Conclusion
As more funds program their algorithmic software to trade Bollinger Bands, the more self-fulfilling they will become, and the more we can trust them as signals for trades. Bollinger Bands should be part of every trader’s arsenal, not just because they work and are simple to understand, but because as more systems use them, they will become increasingly useful and relevant.
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