How to Use Bollinger Bands
From mid-January until early May, Monsanto closed below the lower band at least five times. If the price pulls back within the uptrends, and it stays above the middle band and moves back to the upper band, that indicates a lot of strength. M-Tops were also part of Arthur Merrill's work that identified 16 patterns with a basic M shape. An M-Top occurs when there is a reaction that moves close to or above the upper band. Therefore, the bands naturally widen and narrow in sync with price action , creating a very accurate trending envelope.
The breakout is not a trading signal. The mistake most people make is believing that that price hitting or exceeding one of the bands is a signal to buy or sell. Breakouts provide no clue as to the direction and extent of future price movement. They are simply one indicator designed to provide traders with information regarding price volatility.
John Bollinger suggests using them with two or three other non-correlated indicators that provide more direct market signals. He believes it is crucial to use indicators based on different types of data.
This strategy has become one of the most useful tools for spotlighting extreme short-term price moves. Learn to pounce on the opportunity that arises when other traders run and hide. Bollinger Bands have become an enormously popular market tool since the s but most traders fail to tap its true potential. This intraday strategy picks tops and bottoms based on a clear recovery following an extreme move. Find entry or exit signals or develop a complete system based on average true range.
The Bollinger band is made from three lines plotted on the screen. Usually, the moving average is a simple one SMA. However, recently it has been proved that using an exponential moving average EMA is more lucrative for riding a trend. A typical Bollinger Bands strategy is to look for a break when the two standard deviations are moving away from each other.
There are multiple ways to use the indicator. The most popular one being to look for a breakout when the bands are becoming closer to one another. This indicates a period of low volatility and a break is imminent.
Contrary to the general belief, the Forex market spends most of the time in consolidation. Over seventy percent of the time, prices are moving in a range. Doing that would result in being on the right side of the market for over six months and avoid the noise caused by the fundamental news.
There are two ways to deal with an underlying trend with Bollinger Bands strategies. Both are the result of knowing how to use Bollinger Bands. One is to use the MBB line as entries in the direction of the trend. The red arrows in the chart below show bearish Bollinger Bands signals given by the Bollinger Bands settings mentioned earlier.
The big red candle caused by the U. Presidential election and the Trump effect is nothing but another opportunity that shows how to read Bollinger Bands indicator. As for the take profit, a classical one would be when the price is reaching the opposite Bollinger Band. In this example, as the underlying trend is bearish, the opposite band would be the LBB. For the trades illustrated so far, the target area or the exit point are highlighted in the picture above.
The key to this Bollinger Bands technical analysis approach is to wait for the candle to close. Of course, the examples above use the daily time frame, but the same principle can be successfully used on lower time frames too. Therefore, the drawdown, in case the Bollinger Bands parameters are set on a lower time frame, is not that big like on the daily chart. However, the idea regarding how to interpret Bollinger Bands indicator is the same, no matter the time frame used.
So far, we saw the Bollinger Bands interpretation on a breakout strategy. It is based on how to calculate Bollinger Bands and interpret the standard deviations that indicate how volatile a market is.
However, does a Bollinger Bands reversal strategy exists? The answer is yes, and for this, we need to look for reversal pattern that forms when the price is reaching the extremes UBB and LBB. The perfect reversal patterns are the Japanese candlestick techniques. A great way to learn how does Bollinger Bands work is to look for reversal patterns given by Japanese candlestick techniques.
These are the most representatives and are forming all the time. Like anything related to trading, there is a trick here too. You should ignore all other reversal patterns that are not touching the two volatility lines. The example above shows a dark-cloud cover forming at the end of a bullish trend, with both candles that are part of the reversal pattern touching the UBB volatility line.
This is enough to take a short trade. As a take profit and finding your risk-reward ration, you can use the length of the dark-cloud cover To calculate it, simply measure the highest and the lowest point in the dark-cloud cover pattern.
Then multiply it by 2. The stop loss should be the highest point of the reversal pattern. You can use a bigger risk-reward ratio, but that would not be a realistic approach. In the example above, you seethat the dark-cloud cover acted as a Bollinger Band squeeze indicator as the price action that followed reached the take profit and some more. The same is valid for the hammer reversal pattern that follows. By definition, a hammer is a bullish reversal pattern, meaning a bearish trend must be in place.
Such a tutorial is like a trading plan that has both entry and exit levels. When price moves up, the bands spread apart.
One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. If you said down, then you are correct!
As you can see, the price settled back down towards the middle area of the bands. What you just saw was a classic Bollinger Bounce. The reason these bounces occur is because Bollinger bands act like dynamic support and resistance levels. The longer the time frame you are in, the stronger these bands tend to be.
Many traders have developed systems that thrive on these bounces and this strategy is best used when the market is ranging and there is no clear trend.