Bollinger Bands and Trend Trading - dummies

Bollinger Bands and Trend Trading

By Barry Burns

Bollinger Bands were created by John Bollinger in the 1980s, trademarked by him in 2011, and have enjoyed a wide following by many technical analysis traders. You can use them to help determine trend, strength, and volatility — the variation of the price of a market over time — in a dynamic, adaptive manner.

A market that has high volatility makes a large price movement in a given period of time. A market that has low volatility makes a small price movement in a given period of time. Bollinger Bands can be very useful in identifying price patterns that would otherwise be hard to spot.

Getting a clear signal with Bollinger Bands

Bollinger Bands are one of my favorite tools. They’re easy to read, provide meaningful signals, and measure both trend and volatility in one tool. Bollinger Bands consist of three elements:

  • A simple moving average, usually of intermediate length: A simple 20-period moving average is often the default setting. You can use this average for measuring trend and to calculate the other two elements of the indicator (see the following bullets).

  • The upper band: The upper band is a standard deviation above the simple moving average used in the indicator. Two standard deviations is often the default found on most charting software.

    Standard deviation is the measurement of how far the current price is deviating from an expected norm. In the context of Bollinger Bands, the standard deviation is drawn as lines above and below the expected norm, which is the moving average. In this way, it measures the volatility of the market and strong moves in one direction or another.

  • The lower band: The lower band is a standard deviation below the simple moving average used in the indicator. Two standard deviations is often the default found on most charting software.

Unlike the ADX, which is plotted on a sub graph below the price graph, Bollinger Bands are plotted on the same graph as the price bars and thus give clear signals of price bars interacting with the indicator. In addition to providing indications of direction and volatility, Bollinger Bands are often used to visually show contracting market conditions, which many traders use to anticipate large breakout moves.

The figure shows a squeeze where the Bollinger Bands contract, signaling a low volatility cycle, after which traders look for a breakout of the narrow range of trading.

[Credit: Figure by Barry Burns]
Credit: Figure by Barry Burns

Trading Bollinger Bands the right way

You can choose from many rules and signals when trading Bollinger Bands. One signal that indicates a new trend may be starting is waves.

When the market makes relatively larger moves (in both time and price) in the direction of the trend, such moves are called impulse moves. When the market makes relatively smaller moves (in both time and price) against the direction of the trend, such moves are called corrective moves.

Bollinger Bands provide a way to objectively measure impulse and corrective waves:

  • When price bars move far enough to reach the upper or lower Bollinger Band, you may consider that an impulse move, providing evidence of strength in that direction and therefore an indication that a trend may be starting.

  • The corrective move against the trend often retraces back to the moving average used in the indicator but definitely shouldn’t move so far as to touch the opposite Bollinger Band. If it does, then it indicates you have an impulse wave in the direction of that move, and it negates the impulse move in the previous direction.

The following figure provides an example of an impulse move that reaches the upper Bollinger Band, a corrective leg against the trend that doesn’t reach the lower Bollinger Band, and another impulse move that again reaches the upper Bollinger Band.

[Credit: Figure by Barry Burns]
Credit: Figure by Barry Burns