The Complete Guide to Bollinger Bands Trading Strategy
Bollinger Bands are one of the most popular technical indicators used by traders today. This powerful indicator was developed in the 1980s by famous technical analyst John Bollinger and provides unique insights into market volatility.
In this comprehensive guide, you’ll learn what bollinger bands are, how they are calculated, and most importantly – how to use bollinger bands to find trading opportunities and develop effective bollinger band trading strategies.
What are Bollinger Bands?
Bollinger Bands consist of three lines plotted on top of an asset’s price chart:
- The Middle Band – a simple moving average (SMA) of the asset’s closing price over a set period of time. Usually 20 days.
- The Upper Band – plots 2 standard deviations above the middle band
- The Lower Band – plots 2 standard deviations below the middle band
Here is an example of how Bollinger Bands look on a stock chart:
[Insert image of bollinger bands on chart]
As you can see, the upper and lower bands act as dynamic support and resistance levels that expand and contract based on volatility.
During periods of low volatility, the bands narrow. During periods of high volatility, the bands widen.
The key concepts to understand are:
- The Middle Bollinger Band is a measure of the intermediate-term trend
- The Upper/Lower Bands indicate overbought/oversold levels
- Wider bands signal increased volatility and potential trading opportunity
Now let’s dive into how to properly calculate Bollinger Bands.
How to Calculate Bollinger Bands
Here is the step-by-step process to calculate Bollinger Bands for any asset:
- Determine the number of periods you want for the moving average. Common settings are 20 or 50 days. We’ll use 20 days.
- Calculate the 20 period simple moving average (SMA) of the closing prices.
- Measure the standard deviation of the closing prices over the same 20 day period.
- Plot the Upper Bollinger Band by adding 2 standard deviations above the 20 period SMA.
- Plot the Lower Bollinger Band by subtracting 2 standard deviations below the 20 period SMA.
- The Middle Bollinger Band is simply the 20 period SMA.
That’s it! By calculating the bands using 2 standard deviations, they will adjust dynamically to changes in volatility.
Now that you know how to calculate Bollinger Bands, let’s discuss how to effectively use them in your trading.
Bollinger Bands Trading Strategies
Here are some of the most common and effective strategies to trade with Bollinger Bands:
Bollinger Bounce Setup
When the price touches the outer Bollinger Band, a “bounce” can occur back towards the direction of the moving average. This presents an opportunity to profit from the reversion to the mean.
Here is a step-by-step Bollinger Bounce trade:
- Identify when price hits or nears the upper or lower band.
- Wait for a confirmation candle to close outside the band. This helps avoid premature entries.
- Enter a short position when price closes below the lower band with a stop above it.
- Enter a long position when price closes above the upper band with a stop below it.
- Take profit once price reaches the moving average or opposite band.
This simple strategy allows you to sell high and buy low, profiting from the volatility contractions.
[Insert image example of bollinger bounce setup]
Bollinger Breakouts
Since the bands act as support and resistance, a breakout signals growing momentum. This presents an opportunity to trade the breakout.
Here is how to trade a Bollinger Band breakout:
- Identify a period where price consolidates between the bands, indicating low volatility.
- Wait for price to close outside the upper or lower band, signaling a breakout.
- Enter a long position on an upside breakout above the upper band.
- Enter a short position on a downside breakout below the lower band.
- Place a stop loss on the opposite side of the breakout band.
- Ride the trend and take partial profits at the moving average and opposite band.
[Insert example image of bollinger breakout]
Breakouts from the Bollinger Bands can lead to sustained trends, allowing you to profit from extended moves.
The Squeeze Setup
One of the most powerful Bollinger Band signals occurs when volatility reaches extreme lows, indicated by very narrow bands. This is known as the “squeeze”.
When the bands squeeze together, a violent price expansion often occurs afterwards. By identifying these low volatility squeezes, you can anticipate the forthcoming breakout.
Here are the steps to trading a Bollinger Band squeeze:
- Identify periods where the Upper and Lower Bands are very close together. The closer the bands, the higher chance of expansion.
- Wait for increased volume on the breakout candle as confirmation.
- Buy the upside breakout above the contraction as volatility expands.
- Short the downside breakout below the contraction.
- Place a stop on the other side of the bands and trail it as the breakout continues.
Squeezes are one of the highest probability Bollinger Band signals, allowing you to profit from the ensuing volatility expansion.
[Insert example image of bollinger squeeze setup]
W-Bottoms and M-Tops
Certain price patterns can form within the bands that also signal potential trades. W-Bottoms and M-Tops are two examples.
A W-Bottom forms when price touches the lower band, bounces up, pulls back again to the lower band, and then explodes upwards.
An M-Top forms when price touches the upper band, pulls back, touches the upper band again, and then collapses downwards.
[Insert example images of W-Bottom and M-Top patterns]
These patterns signal extreme oversold and overbought conditions preceding a major reversal.
Now that you understand the signals, let’s go over some tips for effectively trading with Bollinger Bands.
Bollinger Band Trading Tips and Tricks
Here are some key tips for trading Bollinger Bands successfully:
- Use bands on longer timeframes (20 day, 50 day SMAs) for overall trend direction
- Utilize bands on shorter timeframes (5 min, 15 min) for entry triggers
- Wider bands signal high volatility, squeeze signals impending expansion
- Only trade signals in the direction of the trend on higher timeframes
- Volume confirms breakouts – wait for an increase on the breakout bar
- The wider the bands stretch on a signal, the stronger the opportunity
Using Bollinger Bands on multiple timeframes gives you both valuable context on the trend and helps spot high probability entries.
Now let’s go over some common questions traders have about Bollinger Bands.
FAQs About Bollinger Band Trading Strategy
What timeframes are best for trading Bollinger Bands?
Bollinger Bands can be used on any timeframe. Typically longer timeframes like the daily or weekly charts identify the overall trend, while shorter timeframes like 5 min or 15 min are used for entry triggers.
What indicator settings work best for Bollinger Bands?
The standard default settings (20 period SMA, 2 standard deviation bands) tend to work well. You can experiment to find the best number of periods for the asset you are trading.
How wide should the Bollinger Bands be for a high probability trade?
Wider bands indicate higher volatility and more potential for an explosive move. The wider the bands during a signal, the higher probability and larger expected move.
What is the best way to confirm a Bollinger Band signal?
Volume confirmation is very important. Wait for an increase in volume on the breakout candle or a decrease in volume on pullbacks. Divergence with other indicators also adds confidence.
Is it better to buy near the lower band or sell near the upper band?
Trades set up by both the lower and upper bands can be profitable if traded with discipline. Generally selling near the upper band and buying near the lower band works best.
Should I trade the first touch of the bands or wait for multiple touches?
The best approach is normally waiting for 2-3 touches of a band to identify zones and increase probability. Trading the first touch can work but requires quick reaction.
With the right approach, Bollinger Bands can boost your trading strategy by helping you identify high probability opportunities.
Pros and Cons of Bollinger Band Trading
Let’s summarize the key pros and cons of using Bollinger Bands:
Pros:
- Identify overbought/oversold levels
- Time breakouts from periods of consolidation
- Spot trend reversals and extreme price levels
- Adapt to changing volatility conditions
- Easy to interpret signals
Cons:
- Too many signals can lead to overtrading
- Works best with other indicators to confirm
- Bands may be wide during strong trends with no reversals
- Signals can underperform in choppy or ranging conditions
While Bollinger Bands have some drawbacks, the tool provides invaluable information to skilled traders who use it properly.
Conclusion
Bollinger Bands are a versatile technical indicator that can help traders spot high probability opportunities across any market or timeframe.
By properly identifying band squeezes, bounces, breakouts and other patterns, the Bollinger Band trading strategy can boost your chances of success.
The key is using the bands to gain insights into key support/resistance levels, overbought/oversold conditions, volatility, and momentum. With discipline and proper confirmation, Bollinger Bands can significantly improve your trading.
Hopefully this guide gave you a good sense of what Bollinger Bands are, how to use them, and strategies to trade them effectively. The bands should be a core part of every trader’s analysis and can help unlock your trading potential.
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