When it comes to trading stocks, one of the most important tools used by investors is that of Bollinger Bands. This technical indicator was developed by John Bollinger in the 1980s. He developed this as a tool to measure volatility of a stock price from a relative mean. It is a good indicator of volatility as it is calculated by looking at the standard deviation around the mean. Most trading software will construct the bands for you, but as a brief explanation, the Bollinger Bands are calculated as such: middle band = x period moving average
Upper Band = Middle Band + 2 Std Dev
Lower Band = Middle Band – 2 Std Dev
In the above calculations, x is the time period back and Std dev is the standard deviation over this period.
The upper and lower band give an indication of how far away the price is from a mean. Traditionally, traders would merely use the Bollinger bands as an indication of mean reversion. They would merely go long the stock if the price touched the lower band and go short the stock if it hit the upper band. Although it may have worked originally, it is quite simplistic and can often not materialise.
If, however, the trader combines Bollinger bands with other technical indicators, profitable entry and exit points can be identified. There are any number of Bollinger band strategies that one can use. In this post, we will demonstrate the use of more than one set of bands.
Using Different Look back Periods
The great thing about Bollinger band analysis is it’s adaptability. A trader could use a combination of moving average strategies and Bollinger band indicators.
Instead of limiting the analysis to the 20 period Bollinger bands, the investor could also include the 50 period moving average bands. This will allow the trader to make a judgement on the direction of that stock more concretely. The multiple Bollinger bands are used as confirmation indicators. They usually tend to confirm the view of movement in the price.
Given the time period used for the 50 period Bollinger bands, they are usually wider and give an indication of trend deviation over a longer period of time. The 20 period Bollinger bands are narrower and can give an indication of possible reversals in price movement.
For example, if the trader notices that one of the candles has breached the 20 and 50 period Bollinger bands then he may consider shorting the pair given the theory of mean reversion. However, in order to confirm his view on the reversal, the trader would have to monitor the 20 period Bollinger band. If the 20 day Bollinger band appears to be turning lower even though the price has breached it, this is a sign that the reversal is more likely and volatility is being dampened.
This analysis also applies for any long positions when the price may fall below the lower bands.
Using different standard deviations
Another way to combine Bollinger band indicators is to use more than one standard deviation. Instead of only looking at the 2 standard deviation, one could incorporate the 3 standard deviation as well. This will allow the trader to get a sense of the relative size of the movement in the price. The main idea behind this strategy is to spot points in which the price is between the two lower / upper bands and appears to be turning.
Another helpful indicator to use with this analysis is the 200 day EMA (Exponential Moving Average). This will allow the trader further perspective on the prevailing direction. In general, if the price of the asset is above the EMA then this is an indication of a positive trend and is a bullish indicator. It also helps to use individual candle analysis especially when it comes to the closing prices of the candles. For example, if one of the candles appears to close inside the boundary and between the two bands this is an indicator that a reversal is imminent.
Let us take a look at an example in order to get a better idea of how a trader would use this strategy. In the below chart, we have AUD/USD which is plotted over the 5 minute interval. The first thing to note is that the price is above the 200 EMA (in blue). We can also see that one of the 5 minute candles has closed down and between the two Bollinger bands. This is typically a good indicator that the trader should go long the pair. However, in order to best confirm this, the trader should monitor the next candle. As we can see, the next 5 minute candle has indeed reversed and the trader can now place his long position on the trade. The trader can also use similar analysis to determine when to exit the trade. In the above case, the ideal exit point is highlighted. This is the point when the Bollinger bands appear to be tightening and the trend is slowing down.
Like most advanced technical analysis, Bollinger band strategies require some practice before they can be implemented successfully on a successive basis. There are many occasions when a trend may indeed not be reversing and the price may ride the band. However, if you used the strategies above successfully, then the trader would be able to easily spot “false” reversals.