Trading Strategy

Picking Tops and Bottoms in Bollinger Bands

June 27, 2021 | 10:44 am | The 5%ers' Blog > Trading Strategy
June 27, 2021 | 10:44 am
The 5%ers' Blog > Trading Strategy
Picking Tops and Bottoms in Bollinger Bands

Bollinger Band indicator

Bollinger Bands is a technical indicator designed by John Bollinger used to assess market volatility and indicate overbought or oversold conditions.

In this guide, we’ll discuss all the nitty-gritty of Bollinger Bands.

 

How do Bollinger Bands Work?

Bollinger Bands are compried of three lines on a chart. Its middle line denotes the price of the instrument’s SMA (simple moving average). The upper band is marked as the SMA plus two standard deviations, and the lower band reflects the SMA minus two standard deviations.

How do Bollinger Bands work?

 

As a technical analysis tool, Bollinger bands indicate when an asset is overbought or oversold. If the instrument’s price goes towards the top band, it is usually a sign that it is overbought. When the price moves towards the lower band, it usually indicates that it has been oversold.

Bollinger Bands can also be used to note volatility. During periods of slow trade, the bands narrow. Conversely, the bands expand when price changes are volatile. 

When paired with other indicators, Bollinger Bands can assist you in benefiting from overbought and oversold market conditions.

 

When should you use Bollinger Bands?

Bollinger Bands can be used to any timeframe, including weekly, daily, and five-minute charts. You can change the settings to accommodate different trading strategies.

When the price of the instrument advances towards the top band, it indicates that it is overbought. In general, you look to sell when you believe an instrument has been overbought. Conversely, when the instrument’s price moves towards the lower band, it signals that it is oversold, and you buy assets that are oversold.

 

How do you Read a Bollinger Band Indicator?

When you apply Bollinger Bands to a chart, you observe three lines. As previously stated, the center line represents the instrument’s simple moving average (SMA). This is the price average over a set period. It is usually set to a period of 20 days.

You can find a Bollinger band on either side of the SMA. They resemble an envelope enclosing the asset’s price. The standard deviation defines the widths of the bands. The standard deviation denotes the volatility of the instrument’s price changes. In most cases, this is set to 2.0.

Bollinger Band indicator

The period is the number of intervals used to calculate the Bollinger Bands. 

A value of (20, 2) indicates that the period and standard deviation are set to 20 and 2.0, respectively. 

 

How to Trade with the Bollinger Bands?

There are several strategies that you can use with Bollinger bands. Here’s how you can trade with the Bollinger bands: 

Bollinger Double Bottoms

A double bottom occurs when the price of an instrument falls sharply, with significant volume, and closes to the lower Bollinger band. It then temporarily rebounds upward towards the middle band. Then, finally, it drops lower again, this time at a lesser volume, and closes to the lower band.

This pattern shows that the downward pressure has been relieved. The market is shifting from sellers to buyers. Frequently, the next price movement is a significant upward rise off the second low. You look to go long, targeting the middle or upper band.

Let’s take a look at the chart:

Bollinger Double bottoms

 

The first swing low exceeds the lower Bollinger band.

Falling below the Bollinger middle line is a possible confirmation signal.

A crossover below the Bollinger middle line is not always a good confirmation signal. In particular, you should not rely on the middle line crossover if the Bollinger band is narrow.

Bollinger Double Tops

A double top is a bearish reversal pattern. It forms after an uptrend. It is the opposite of the Double Bottom. It is represented as the M pattern. 

As the chart below shows, it is the inverse of the W pattern.

Double Tops

 

The first swing high is above the Bollinger bands.

The second swing high is above the first swing high but stays within the Bollinger band. The middle line crossover can be taken as a confirmation signal.

Bolinger Reversal Strategy

In a reversal strategy, you look for signals that the instrument’s price trend will reverse. For example, the price could gap above the upper Bollinger band but close near the lower band. 

This indicates that the trend will reverse shortly. You can take a short position, aiming for the middle band. Similarly, the price may fall below its lower Bollinger band but close near the interval high. This implies that the trader might go long, targeting the middle band.

Reversal strategy

 

Bollinger Squeeze

This strategy uses band width. The formula for the band width is:

Band width = upper Bollinger band’s value – lower Bollinger band’s value / middle Bollinger band’s value.

Bollinger Squeeze is based on the assumption that assets are continually subject to periods of high volatility followed by periods of low volatility. For example, assets with a six-month low level of volatility, represented by a small distance between Bollinger bands, are more likely to show big breakouts.

You can use other indicators with Bollinger bands to determine which way the asset is most likely to move in the next breakout. 

Bollinger Squeeze

 

As the above chart illustrates, when the value of GBP/JPY hit the six months low, it moved in the upward direction. 

 

Limitations of Bollinger Bands

Bollinger Bands are a useful technical analysis indicator, but they have several limitations.

Reactive, not predictive – Bollinger bands are based on a simple moving average of an instrument’s previous data points. As a result, the bands always react to price changes rather than forecasting them. Bollinger bands, in other words, are reactive rather than predictive.

False signals – Bollinger Bands are also prone to generating false signals. A fake breakout, for example, occurs when the price of an instrument crosses through the entry point. It indicates a trade but then reverses its course. As a result, you lose the trade.  

Don’t work with all strategies – You should also understand that standard Bollinger bands settings do not work for all strategies. Long-term traders may want to employ more periods and a higher standard deviation. Short-term traders may prefer fewer periods and a lower standard deviation.

Because they have certain limitations, you should use Bollinger bands in conjunction with other technical analysis tools. You can use Moving Averages, Stochastic indicators, and trend lines with the Bollinger bands. 

 

Summary of Bolinger Bands Top and Bottom

Bollinger bands work best with the double tops and bottoms pattern and signal a potential reversal. Strong trends, particularly those that emerge following the

breakout of a trading range will result in an increase in volatility, causing the bands to first move apart.

Besides this, consider placing a buy entry point above the upper band if you want to go long when trading a squeeze.

Once executed, you might put an initial stop under the breakout formation low or under the lower band. If you are shorting, you may set a short sell entry point below the lower band in the squeeze area and, once done, consider setting your initial stop above the high of the breakout formation or above the upper band.

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