Bollinger Bands are non-static indicators and they change their shape based on recent price action and accurately measure momentum and volatility.
Bollinger Bands are one tool that can help you decide when to make your move by illustrating the relative strength—or momentum—of a stock.
Bollinger considers the price of the stock:
- relatively low (attractive) if it is near the lower band, and
- relatively high (overvalued) if it’s near the higher band.
Trading signals that are generated by how the price of the stock or security interacts with the bands.
- when the stock breaks through the upper band (a resistance level), it generates a BUY signal.
- when it breaks below the lower band (a support level), it’s a SELL signal.
Bollinger Bands can also provide a unique assessment of Volatility.
- Narrowing Bollinger Bands could suggest that volatility is decreasing—as investor sentiment potentially becomes more optimistic or complacent.
There are just a few things you need to pay attention to when it comes to using Bollinger Bands ® to analyze trend strength:
During strong trends, price stays close to the outer band
If price pulls away from the outer band as the trend continues, it shows fading momentum
Repeated pushes into the outer bands that don’t actually reach the band show a lack of power
A break of the moving average is often the signal that a trend is ending
These are some of the things you can do with bollinger bands
Looking for The Squeeze to determine directional breakouts
Trading M Tops and W bottoms
Overlapping Bollinger Bands of different time periods for even clearer setups
Combining other Technical Analysis tools such as Oscillators or Support &Resistance
Using Multiple Time Frames to spot longer term trends
The role of the moving average: During trends, the moving average holds very accurately and a break of that moving average is usually a meaningful signal that the sentiment has shifted.
1. Trading within the bands
It is based on the premise that the vast majority of all closing prices should be between the Bollinger Bands. That stated, then a stock’s price going outside the Bollinger Bands, which occurs very rarely, should not last and should “revert back to the mean”, which generally means the 20-period simple moving average.
A trader buys or buys to cover when the price has fallen below the lower Bollinger Band.
The sell or buy to cover exit is initiated when the price pierces outside the upper Bollinger Band.
Rather than buying or selling exactly when the price hits the Bollinger Band, the more aggressive approach, a trader could wait and see if the price moves above or below the Bollinger Band and when the price closes back inside the Bollinger Band, then the trigger to buy or sell short occurs. This helps to reduce losses when prices breakout of the Bollinger Bands for a while. However, many profitable opportunities would be lost. Also, some traders exit their long or short entries when price touches the 20-day moving average.
2. Trading outside the bands (Breakout)
One of the ways to trade using the Bollinger Bands is finding a range and then waiting for its breakout. Breakouts occur after a period of consolidation, when price closes outside of the Bollinger Bands. Other indicators such as support and resistance lines can prove beneficial when deciding whether or not to buy or sell in the direction of the breakout.
Upper Breakout: When price breaks above the upper Bollinger Band after a period of price consolidation. Other confirming indicators are suggested, such as resistance being broken in the chart
Lower Breakout: When price breaks below the lower Bollinger Band. It is suggested that other confirming indicators be used, such as a support line being broken.
You should know that after a range breakout, the very first reversal signal is not indeed a reversal signal. It is a continuation signal. If the candlesticks movements make you confused, you can shift to the line chart from time to time and find the real support and resistance of the range.
3. Trend Trading
It occurs during a strong uptrend, when prices tend to stay in the upper half of the Bollinger Band, where the 20-period moving average (Bollinger Band centerline) acts as support for the price trend. The reverse would be true during a downtrend, where prices would be in the lower half of the Bollinger Band and the 20-period moving average would act as downward resistance.
With a double bottom, you note the first time the price touches the lower band and then wait to see where the next low occurs relative to the band. (Remember, a price that’s at or near the low could indicate a buy signal). In a double bottom scenario, a trader may have higher odds of success if the first low is touching or outside the lower band, then the price reacts and rises close to the middle band, and then the second low is inside the lower band.
The Classic M Top
The classic M top is formed by a push to a high, followed by sell off reaction, and then a test of the previous high. The second high can be higher or lower than the first high. Watching the price behave like this, a trader may wonder if the stock is in a new uptrend, or if it has met its resistance. The Bollinger Band® may help to answer this. In a Classic M Top, the first high is touching or outside the upper band, the reaction gets close to the middle band (the moving average); and the second high is inside the upper band. And again, the second high can be higher or lower than the first high. The fact that the second high is within the upper band suggests that it is a lower high on a relative basis. For many traders, this second high then signals a sell.
Three Pushes to High
A "three pushes to high" top often develops as a leading edge of a larger, longer topping formation. Typically the way it forms is like this: the first push will make a new high outside the upper band; the second push will make a new high and touch the upper band; the third push will make a new high, but will be within the upper band. That may be a reliable indicator of decreasing momentum. With it, you may notice there is also decreasing volume.
Walking the Bands
This bears repeating: just because a price touches an upper or lower band, it does not necessarily mean there is a signal. A mistake some traders make is that they treat any tag of the band as a trigger. But actually, in a sustained uptrend, there will be repeated touches of the upper band, and vice-versa: in a sustained downtrend there may be repeated touches of the lower band with some closes below it in a decline; this is called walking the bands.
Signaling the Starts or the Ends of Trends
Bollinger Band® can also indicate the ends of strong trends. Strong trends cause an expansion in volatility that will cause the bands to initially move apart, meaning the lower band will actually move down opposite the trend. When a trend begins to wane, the lower band in an uptrend will turn back up, which can be a signal that the move might be over (at least for a while).
Riding the bands:
- Another Bollinger bands strategy is riding the bands, this is when we use the bands as a trend recognition tool.
- During strong trend moves, the candles tend to almost stick to the upper or lower band.This occurrence shows the trader that the trend is likely to continue and has power behind it.
- John Bollinger, the bands creator, calls a move that touch the bands a ‘tag’ of the band. this is not exactly a signal but it does denote a strengthening or weakening market.
Trading a squeeze
- A Bollinger Band “squeeze” as Bollinger himself describes it, occurs when volatility reaches a relative low. This squeeze can frequently be followed by a period of increased volatility, and may result in a significant move by the stock to the upside or the downside
- You might consider placing a buy entry point above the upper band, or a sell entry point below the lower band in the squeeze area.
- For buys, consider placing an initial stop under the low of the breakout formation or under the lower band.
- For sells, consider placing your initial stop over the high of the breakout formation or over the upper band. Then, to exit the trade, consider using a trailing stop: a fixed dollar fixed percentage or parabolic SAR.
Or another exit strategy (to capture longer moves) could be to exit when the stock tags the opposite band (i.e. the lower band if you’re long, or the upper band if you’re shorting).