Stocks Trading with Bollinger Bands

Introduction

Bollinger Bands are a technical trading tool created by John Bollinger in the early 1980s. They arose from the need for adaptive trading bands and the observation that volatility was dynamic, not static as was widely believed at the time.

The purpose of Bollinger Bands is to provide a relative definition of high and low. By definition prices are high at the upper band and low at the lower band. This definition can aid in rigorous pattern recognition and is useful in comparing price action to the action of indicators to arrive at systematic trading decisions.

Bollinger Bands consist of a set of three curves drawn in relation to securities prices. The middle band is a measure of the intermediate-term trend, usually a simple moving average, which serves as the base for the upper band and lower band. The interval between the upper and lower bands and the middle band is determined by volatility, typically the standard deviation of the same data that were used for the average. The default parameters, 20 periods and two standard deviations, may be adjusted to suit your purposes.


Calculation

  • Description: Bollinger bands are an upper band (UB) and a lower band (LB) which are a default of two standard deviations (STDEV) of the n most recent prices (Pn), above and below a simple moving average (SMA) of the n most recent prices.
  • Calculation:
        SMA = (P1 + P2 + P3 + P4 + ... + Pn) / n (20-day simple moving average).
        UB = SMA + STDEV(P1 ... Pn) (20-day SMA + (20-day standard deviation of price x 2)).
        LB = SMA - STDEV(P1 ... Pn) (20-day SMA - (20-day standard deviation of price x 2)). 
Trading Use

Bollinger bands are an indication of the volatility of recent prices. If the recent prices have a larger range than the previous prices, the Bollinger bands will expand. If the recent prices have a smaller range than the previous prices, the Bollinger bands will contract.

Bollinger bands are used in many different ways by different traders. Some traders make trades when the price moves above or below the Bollinger bands (i.e. when the price breaks out of the Bollinger bands channel). Some traders make trades near the moving average, and use the Bollinger bands as targets. Bollinger bands are also used by options traders that trade using volatility, because recent volatility is part of the calculation of options' premiums.

Basic Application of Bollinger Bands

So you want to learn how to master Bollinger band trading. That's a smart move because Bollinger bands are probably the best indicator you can use to achieve near perfect entry and exit consistently.

There are the beginning concepts about trading Bollinger bands and then there are the advanced topics. Combined you posses a tool for insight that you really cannot get from any other indicator.
Bollinger band trading requires that you understand all of these concepts completely in making trading decisions using the bands.

1. Bollinger band squeeze
2. Bollinger band continuation
3. Bollinger band reversal

What makes Bollinger bands even more unique are the advanced concepts that accompany these signals that form.

As you observe a continuation, a squeeze or a reversal pay special attention to how the upper and lower bands respond to approaching price action.

Take a look at the following diagram closely and with careful study because grasping the following is the golden key to successful Bollinger band trading.


Advanced Application of Bollinger Bands

The candlesticks present represent current approaching price action to the upper or lower band. Let’s start with #1.

1. Extremely bearish, price is falling to a lower band and the KEY is of course watching both the upper and lower band as price approaches. In this case the upper is rising while the lower is falling indicating not only a potential explosion in price but one to the downside is extremely likely.

2. Extremely bullish, price is rising to the upper band and the KEY is keeping a watchful eye on BOTH band as price approaches. In this case the upper band heads UP and the lower band falls, indicating a potential price explosion to the upside.

3. Price approaches the lower band while the upper and lower band remains flat. This is very insignificant and should be ignored unless things change.

4. Price approaches the upper band while the upper and lower bands remain flat. This is also insignificant and best left for the amateurs to enter.

5. Bearish candlestick at a lower band while band constrict - this is a sign that price is likely at least for now going nowhere. Wait do not enter.

6. Same here, a bullish candlestick at the upper band while the bands are constricting is a sign that not much is about to happen just yet.

7. Like #1 this is a sign that price is going to make a nice move but the lack of the upper band hooking up indicates that the move for now won't necessarily be explosive.

8. Also similar to its counterpart in that price will likely move but not to the explosive level that would be expedited if the lower band was hooking downward.  The lack of the lower band hooking down limits the potential move here.


Sources and Additional Information:

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