Bollinger bands are technical market indicators that were developed by John Bollinger and are used to measure market volatility.
It is made up of two lines drawn on the price chart with the upper line above the price, a moving average in the middle and the lower line below the price forming channels.
The moving average line runs in the middle of the band and is normally set at 20 period and the two lines are plotted 2 standard deviations above and below the moving average.
The band helps to show whether the market is crowded or noisy or quiet. The bands widen when the market volatility increases and tend to contract when it falls.
The Bollinger bands work well in both trending and ranging markets.
How do you enter trades using Bollinger bands in a trending market
A strong uptrend is indicated when price moves along the upper band and a strong downtrend is indicated when price moves along the lower band. If it fails it is an indication for a fall in momentum.
The signals for entry are on the middle line. But of course we will need extra confirmation signal for trend continuation. It is very important to combine the bollinger bands with other strategies like candlesticks patterns to get a stronger signal.
On the chart below, our entries to ride with the market (follow trend), would be the levels with candlestick formations on the middle band as shown. Buy 1 & 2(engulfing), Sell 1(engulfing), and sell 2 (doji+engulfing)
When price in an uptrend falls and touches the lower band, this may be a sign for change in the trend direction and the reverse is true for a downtrend. Prepare for a long price rally in a new trend direction. Let’s see what the above chart says.
Note on the chart above, when price touched the lower band at A, the trend changed to the down side from the previous uptrend. Then at B from downtrend to the upside and this happens so frequently. These are very important warnings to take when trading trending markets using Bollinger bands. These warnings call for you to book your profits and tighten your stops. At this point you can also pepare for new opportunities in the direction of the new trend.
Also when trading in a trending market, and the bands expand, it indicates increase in volatility so you are warned to adjust your stops to cater for these big moves so that you are not hit out of the market immediately after your entry.
How to enter trades using Bollinger bands in a ranging market
In ranging markets, as price moves along the upper line and the lower line of the bands, it tends to respect these levels by finding support and resistance. Therefore these lines can be treated as dynamic levels of support and resistance. As price bounces of the upper line, it gives a sell signal and a bounce on the lower line it give a buy signal.
Price movements between the bands is likely to bounce either on the upper line giving a sell signal or on the lower band giving a buy signal.
A candle stick pattern on the upper or lower band would be an added strength to the signal. The take profit levels are on the upper and lower band for sell and buy respectively. The chart below shows how several opportunities on buys and sells would be taken.
Trading breakouts on Bollinger bands
You can also take advantage of a breakout after the squeeze of the bands(congestion) and buy at the break of the upper band and sell at the break of the lower band.
On contraction or squeeze of the bands, it is an indication of very low volatility and this may result to price breakout either on the upper side or lower side.This congestion period indicate a possible reversal /change in trend direction as price bounces off the lower and upper band. If price breaks the upper band, there is a possible uptrend, buy signal. On a break of a lower band it signals a down trend, sell signal.
On the chart below, the highlighted zones, are the band contractions from the congestion. A break and close of candle above the band beyond the congestion is the signal for a buy entry.
The above chart shows how to trade break outs on dynamic resistances using bollinger bands. Confirmation for our buy signals was given by the close of a bullish candlestick above the upper band resistance after the break. Stop loss should be set slightly below the lower band below the low and take profit target on the next resistance level. Take a look at the chart above.
How long you should hold an open position, is a personal thing for all traders. The decision is all yours. You know what your goals are as a trader, the kind of strategy you use to trade. All this starts from what you are? and What you want? If I am to answer, this...