Bollinger Bands? Are We Celebrating?
Aside from being a very nice French Champagne (James Bond’s favorite, I believe), Bollinger, John Bollinger is the name of a gentleman who developed a technical trading tool in the early ‘80s that we call the Bollinger Bands (I’ll try to refrain from making a music pun here.) While there is nothing complex about the Bollinger Bands, they can be a powerful signal to enter/exit a position.
What are Bollinger Bands?
The Bollinger Bands are a simple indicator that consists of a moving average (20 Simple Moving Average on the Close by default) and two additional bands (one above and one below) at a fixed standard deviation of the same last 20 (by default) bar closes that are used to calculate the moving average. By default the bands are two standard deviations from the moving average. The result is, you have outer bands that follow a moving average. Meaning the outer bands expand during trending times and contract during consolidation times. This is a great solution to finding a target for trading bounces from moving average. (Click here to learn more on the moving average strategy.) Or using them to find a place to trade a snap back to the moving average. But we’ll talk about Bollinger Band strategies in a little bit.
The Bollinger Bands can be used on any trading instrument and any time frame. The calculations are based strictly on the price action and the defaults can be changed to smooth the bands out or to make them more responsive. A Simple Moving Average longer than 20 periods can be used to smooth the bands and a larger than two standard deviation figure can be used to reduce the number of trade signals produced by the bands, thus making the signals more significant.
How Can I Profit with the Bollinger Bands?
There are several ways to profit using the Bollinger Bands. I’ll present one good strategy here and leave others for a future article.
In addition to using the Bollinger Bands with the default 20 period Simple Moving Average and the 2 Standard Deviations, I recommend you add a 200 period Simple Moving Average indicator. The 200 SMA will be used to set the trend direction. The trend will be determined by the position of the current price with respect to the 200 SMA. If price is below the 200 SMA, only take short positions. If price is above the 200 SMA, only take long positions.
Enter the trade when price touches the outside edge of the Bollinger Band. If price is below the Bollinger Band, you will only trade short when the price touches the top of the Bollinger Band.
If price is below the Bollinger Band, you will only trade long when the price touches the bottom of the Bollinger Band. You will exit the trade (hopefully with profit) when the price touches the opposite side of the Bollinger Band. There are times when the price action will touch the Band and continue moving in the same direction. If you have an open position and price pushes through the 200 SMA, exit the trade immediately.
How Should I Manage My Bollinger Bands Trade?
Your Stop Loss and Trade Size will depend upon your account size and tolerance for pain. I recommend risking a maximum of 2% of your account on each trade. The stop loss will depend upon your time frame and trading instrument. I would look at the historical candles on your trading instrument and time frame. This tells you how far the price has moved against the strategy in the past to determine the amount you want to allow your trades to swing before you close them. Make this decision in advance to be sure that you don’t “change your mind” while you’re in the trade. These decisions are best made in advance when you are not under the pressure of a losing position.
As I’ve said with prior strategies, you can close half of your trade at the target and set the Stop Loss to Break-even (don’t forget the spread and commissions) and let it run.
Understand that price does not always drop immediately when touching the Band. Sometimes it continues in the direction for quite a while, so you may have to endure some pain before it moves in your direction – or you may “leave money on the table” if it continues to move after you’ve exited the trade.
As always, stick to your trading plan and be safe. Have fun!