Three Bollinger Bands Strategies That You Need to Know
Reading time: 21 minutes
This article will provide professional traders with everything they need to know about Bollinger Bands. It will answer questions such as: What are Bollinger Bands?, How to interpret Bollinger Bands, and it will provide three key Bollinger Bands strategies that traders need to know, as well as some advanced strategies to consider, and will conclude with 15 tips for trading with Bollinger Bands.
What are Bollinger Bands?
John Bollinger, creator of the Bollinger Bands® defines Bollinger bands as ''a technical analysis tool, they are a type of trading band or envelope''. Bollinger bands use a statistical measure known as the standard deviation, to establish where a band of likely support or resistance levels might lie. This is a specific utilisation of a broader concept known as a volatility channel. A volatility channel plots lines above and below a central measure of price. These lines, also known as envelopes or bands, widen or contract according to how volatile or or non-volatile a market is.
Bollinger Bands® measure market volatility and provide lots of useful information, including:
- Trend continuation or reversal
- Periods of market consolidation
- Periods of upcoming large volatility breakouts
- Possible market tops or bottoms, and potential price targets
The Bollinger Bands® consist of three bands, which revolve around a centred simple moving average (SMA), with the default value of 20, of which 85% of the time, the price is held within the following boundaries:
- Lower band – SMA (minus two standard deviations)
- Upper band – SMA (plus two standard deviations)
Interpreting Bollinger Bands
The most basic Bollinger bands interpretation is that the channels represent a measure of 'highness' and 'lowness'. Let's sum up three key points about Bollinger bands:
- The upper band shows a level that is statistically high or expensive
- The lower band shows a level that is statistically low or cheap
- The Bollinger bandwidth correlates to the volatility of the market
This is because the standard deviation increases as the price ranges widen and decrease in narrow trading ranges.
- In a more volatile market, Bollinger bands widen
- In a less volatile market, the bands narrow
The Bollinger Bands® contain a default setting in Forex as (20,2) - (and these are the settings that will be used in the diagrams featured later in this article). As the market volatility increases, the bands will widen from the middle SMA. Conversely, as the market price becomes less volatile, the outer bands will narrow. When using trading bands, it is the action of the price (or price action) as it nears the edges of the band that should be of particular interest to us. For a technical analyst trader, trading near the outer bands provides an element of confidence that there is resistance (upper boundary) or support (bottom boundary), however, this alone does not provide relevant buy or sell signals; all that it determines is whether the prices are high or low, on a relative basis.
Given this information, a trader can enter either a buy or sell trade by using indicators to confirm their price action. Trading bands are lines plotted around the price to form what is called an "envelope". Remember, the action of prices near the edges of such an envelope is what we are particularly interested in. The default Bollinger Bands® formula consists of:
- A N-period moving average (MA)
- An upper band at K times and a N-period standard deviation above the moving average (MA + Kσ)
- A lower band at K times and a N-period standard deviation below the moving average (MA − Kσ)
The Bollinger Bands® can be applied to virtually any market or security. For all markets and issues, a 20-day bollinger band calculation period is a good starting point, and traders should only stray from it when the circumstances compel them to do so. As you lengthen the number of periods involved, you need to increase the number of standard deviations employed. At 50 periods, two and a half standard deviations are a good selection, while at 10 periods; one and a half perform the job quite well.
50 Periods with 2.5 Standard Deviation
10 Periods with 1.5 Standard Deviation
Upper band = 50 Day SMA + 2.5 (S)
Upper Band = 10 Day SMA + 1.5 (S)
Middle Band = 50 Day SMA
Middle Band = 10 Day SMA
Lower Band = 50 Day SMA - 2.5 (S)
Lower Band = 10 Day SMA - 1.5 (S)
Daily Trading with DBBs (Double Bollinger Bands)
Ms Kathy Lien, a well-known Forex analyst and trader, described a very good technique for the Bollinger Bands indicators combo, namely, the DBB – Double Bollinger Bands strategy. In her book 'The Little Book of Currency Trading', she wrote that this was her favourite method. Originally, the DBB can be applied to technical analysis for any actively traded asset traded on big liquid markets like Forex, stocks, commodities, equities, bonds, etc.
This is how you apply it on your chart:
- Insert the Bollinger Bands® on the chart
- Go to 'Settings' and select two standard deviations and a 20 period SMA
- Insert a second set of the Bollinger Bands® with a different color
- Go to 'Settings' and select 1 standard deviation and a 20-period SMA
Source: Admiral Markets Platform - Settings for Bollinger Bands
Source: Admiral Markets Platform - Settings for Bollinger Bands
When the chart has been set up, we need to mark the zones next.
Source: GBPJPY H4 Chart - Admiral Markets Platform - Data Range: Jul 10, 2017 - Aug 18, 2017
- A1: The upper BB (Bollinger Band®) line that is two standard deviations away from line X, which is the 20-period simple moving average (SMA)
- B1: The upper BB line that is one standard deviation from the 20-period SMA
- X: The 20-period SMA of the H4. This serves as both the center of the DBBs, and the baseline for determining the location of the other bands
- B2: The lower BB line that is one standard deviation from the 20-period SMA
- A2: The lower BB line that is two standard deviations from the 20-period SMA
These bands represent four distinct trading zones used by traders to place trades.
Source: GBP/JPY H4 Chart - Admiral Markets Platform - Data Range: Jul 10, 2017 - Aug 18, 2017
- The Buy Zone is between lines A1 and B1
- The Neutral Zone 1 between lines B1 and X
- The Neutral Zone 2 between lines X and B2
- The Sell Zone is between lines B2 and A2
According to the main theory behind the DBBs, Ms Kathy Lien described that we should combine the two middle areas and then focus on three zones:
- The upper quarter
- The middle half
- The bottom quarter
The DBB Buy Zone
When the price is within this upper zone (between the two upper lines, A1 and B1), it tells us that the uptrend is strong, and that there is a higher chance that the price will continue upward. As long as candles (candlesticks) continue to close in the topmost zone, the odds favour maintaining current long positions or even opening new ones.
The DBB Sell Zone
When the price is in the bottom zone (between the two lowest lines, A2 and B2), the downtrend will probably continue. That tells us that as long as the candles close in the lowest zone, a trader should maintain current short positions or open new ones.
The DBB Neutral Zone
When the price gets within the area defined by the one standard deviation bands (B1 and B2), there is no strong trend, and the price is likely to fluctuate within a trading range, because momentum is no longer strong enough for traders to continue the trend. The 20-day simple moving average (X) that serves as the baseline for the Bollinger Bands® is in the centre of the zone.
Source: GBP/JPY H4 Chart - Admiral Markets Platform - Data Range: May 11, 2017 - June 23, 2017
According to the rules, whichever zone the price is in will signal whether you should be trading in the direction of the trend, long or short, depending on whether the trend is increasing upward or decreasing downward. Basically, if the price is in the upper zone, you go long, if it's in the lower zone, you go short. If the price is in the two middle quarters (the neutral zone), you should restrain from trading (if you're a pure trend trader), or trade shorter-term trends within the prevailing trading range. Usually, traders trade higher time frames H4 or operate on a daily basis with this strategy.
Bollinger Bands® Scalping
The Bollinger band scalping strategy uses 5 indicators which are applied on the chart:
- Bollinger Bands® (14,1), green
- Admiral Markets Pivot (H1)
- Bill Williams' Awesome Oscillator
- RSI (14)
- EMA (Exponential Moving Average) - (4), red
The time frame for trading this Forex scalping strategy is either M1, M5, or M15. Targets are Admiral Pivot points, which are set on a H1 time frame. A stop loss is placed below the interim Admiral pivot support (for long trades) or above the interim Admiral Pivot resistance (for short trades). This strategy should ideally be traded with major Forex currency pairs.
Source: EURUSD - Admiral Markets Platform M5 Chart - Data Range: Aug 18, 2017
When the 4 EMA crosses up through the middle Bollinger Band® at the same time, the Chaos Awesome Oscillator should be crossing their zero lines, going up, and the RSI should be coming up and crossing its 50 line.
Source: EUR/USD - Admiral Markets Platform M5 Chart - Data Range: Aug 17-18
Bollinger Band® Squeeze with Admiral Keltner
This strategy uses two indicators which are applied on the chart:
- Bollinger Bands
- Admiral Markets Keltner
With both the Bollinger Bands® and Admiral Keltner indicators, traders should consider using the following default settings that are used on the vast majority of trading platforms:
- Bollinger Bands: Length 20, Standard Deviation 2
- Keltner Channels: Length 20
There are a lot of Keltner channel indicators openly available in the market. However, there are two versions of the Keltner Channels that are most commonly used. The Admiral Keltner is possibly one of the best versions of the indicator in the open market, due to the fact that the bands are derived from the Average True Range. You should not only be sure that you're using the formulation that uses the Average True Range, but also that the centre line is the 20-period exponential moving average. The Admiral Markets Keltner indicator has all the settings correctly coded in the indicator itself, and it should look something like this:
Source: Admiral Keltner Indicator
Understanding this term is the key to understanding how a Bollinger Band® detects and displays fluctuations in the degree of volatility. Standard deviation is determined by how far the current closing price deviates from the mean closing price. The general concept is that the farther the closing price is from the average closing price, the more volatile a market is deemed to be, and vice versa. That is what determines the degree of contraction or expansion of a Bollinger Band®.
Source: GBP/JPY H4 Chart - AM MetaTrader MT4 Platform - Accessed: June 16, 20:00 PM 2017
In the chart above, at point 1, the blue arrow is indicating a squeeze. At point 2, the blue arrow is indicating another squeeze. This is also the case with point 3. What's difficult about this situation is that we still don't know if this squeeze is a valid breakout. What we now need to do is quantify how narrow the squeeze should be in order to qualify for a Bollinger Bands® With Admiral Keltner Breakout Strategy breakout setup.
The way we do this is to add the Admiral Keltner channel to the chart:
Source: GBP/JPY H4 Chart - AM MT4 Platform - Accessed: June 16, 20:00 PM 2017
- Bollinger Bands = Green
- Keltner Channel = Red
In the chart above, we have the Admiral Keltner Channel overlaid on top of what you saw in the first chart, so we can start looking for a proper squeeze. You should only trade a setup that meets the following criteria (that is also shown in the chart below):
Source: GBP/JPY M30 Chart - AM MT4 Platform - Accessed: March 10, 18:30 PM 2017
- Consider only taking a Bollinger Bands® With Admiral Keltner Breakout Strategy trade when both the upper and lower Bollinger Bands® go inside the Keltner Channel. That is the only 'proper way' to trade with this strategy.
- The yellow highlighted columns depict examples of the Bollinger Bands® (green lines) going inside the Keltner Channel (red lines).
- At those zones, the squeeze has started.
- When the Bollinger Bands® (both green lines) start to come out of the Keltner Channel (red lines), the squeeze has been released, and a move is about to take place.
- Wait for a buy or sell trade trigger.
The Bollinger Bands® and Keltner Channels notify you when a market is transitioning from a lower volatility to a higher volatility. Using these two indicators together will provide more strength, compared with using a single indicator, and both indicators should be used together.
Source: GBP/JPY M30 Chart - AM MT4 Platform - Accessed: March 10, 18:30 PM 2017
- Buy: When a squeeze is formed, wait for the upper Bollinger Band® to cross upward through the upper Keltner Channel, and then wait for the price to break the upper band for a long entry.
- Sell: When a squeeze is formed, wait for the lower Bollinger Band® to cross through the downward lower Keltner Channel, and then wait for the the price to break the lower band for a short entry.
- After both the squeeze and release have taken place, we simply need to wait for the candle to break above or below the Bollinger Band®, and then take the trade. Another example is shown below:
Source: GBP/JPY M30 Chart - AM MT4 Platform - Accessed: February 23, 00:00 AM 2017
In the example above, we can also see that there was no entry after the release, because there was no candle breakout that could have triggered the trade. The recommended time-frames for this strategy are M30-D1 charts. This strategy can be applied to any instrument. Intraday breakout trading is mostly performed on M30 and H1 charts. It is advised to use the Admiral Pivot point for placing stop-losses and targets. The stop-loss for buy trades is placed 5-10 pips below the Bollinger Band® middle line, or below the closest Admiral Pivot support, while the stop-loss for short trades is placed 5-10 pips above the Bollinger Bands® middle line, or above the closest Admiral Pivot support. Target levels are calculated with the Admiral Pivot indicator. For a M30-H1 chart, we use daily pivots, for H4 and D1 charts, we use weekly pivots. Both settings can be changed easily within the indicator itself.
Source: EUR/USD M30 Chart - AM MT4 Platform - Accessed: June 16, 22:00 PM 2017
Two Advanced Bollinger Bands Strategies For Professional Traders
Strategy 1: Bollinger Band Breakout Strategy
Source: GBPUSD Daily Chart - Data Range: 2 Dec 2014 - 10 Oct 2016
This is a long-term trend-following strategy and the rules are simple:
- You take a long position if the previous close breaks above the upper band
- You take a short position if the previous close drops below the bottom channel.
The image above shows a daily chart of the GBP/USD currency pair with Bollinger bands 2.5 standard deviations away from a 200-day moving average. See how we get a sell signal in June 2016 followed by a prolonged downtrend?
The downtrend persists all the way through to the most recent part of the chart in October 2016. Also notice that there is an earlier sell signal in February that ended up being a false signal. Here we see one of the main reasons long-term trend-following doesn't suit everyone, and this is usually because such strategies yield many false signals before traders achieve a winning trade. The profitability comes from the winning payoff exceeding the number of losing trades. Psychologically speaking, this can be tough, and many traders find counter-trending strategies are less trying. Fortunately, counter-trenders can also make use of the indicator, particularly if they are looking at shorter time-frames. You can easily adapt the time-frame if you are swing trading or day trading using Bollinger bands.
Strategy 2: Counter - Trend Trading Indicator Strategy
The chart below shows an hourly chart for the EUR/USD currency pair with Bollinger bands and a RSI. The default settings in MetaTrader 4 were used for both indicators.
Source: EURUSD Hourly Chart - Data Range: 8 Sep, 2016 - 15 Sep 02:00 AM 2016
The market in the chart featured above is for the most part, in a range-bound state. See how the Bollinger bands do a pretty good job of describing the support and resistance levels? It's not precise, but the upper and lower bands do broadly match where the direction reverses. Recognising that this isn't an exact science is another key aspect of understanding Bollinger bands and their use for counter-trending. When the market approaches one of the bands, there is a good chance we will see the direction reverse sometime soon thereafter. A counter-trender has to be very careful however, and exercising risk management is a good way of doing so.
Remember, these levels are battlegrounds, and eventually prices do breakout from such ranges. Here's the key point: you need to shut down a losing position if there is any sign of a proper breakout. In the chart above, an RSI has been added as a filter to try and improve the effectiveness of the signals generated by this Bollinger band strategy. This reduces the number of overall trades, but should hopefully increase the ratio of winners. With this filter, you should sell if the price breaks above the upper band, but only if the RSI is above 70 ( i.e. indicating an overbought market). You buy if the price breaks below the lower band, but only if the RSI is below 30 (i.e. indicating an oversold market). It's also a good idea in general to use a secondary indicator like this to confirm what your primary indicator is saying.
Tips for Bollinger Band® Trading
- The Bollinger Bands® provide a relative definition of high and low.
- The relative definition can be used to compare price action and indicator action, to arrive at rigorous buy and sell decisions.
- Appropriate indicators can derive from momentum, volume, sentiment, open interest, intermarket data, etc.
- Volatility and trend have already been deployed in the construction of the Bollinger Bands®, so their use for confirmation of price action is not recommended.
- The indicators used should not be directly related to one another. For example, you might use the 'one-momentum' or 'one-volume' indicator successfully, but the two-momentum indicators aren't better than one.
- The Bollinger Bands® can also be used to clarify pure price patterns such as M-tops and W-bottoms, momentum shifts, etc.
- The price can, and does, walk up the upper Bollinger Band® and down the lower Bollinger Band®.
- Closes outside the Bollinger Bands® are continuations, not reversal signals (this has been the basis for many successful volatility breakout systems.)
- As the default parameters for the moving average line is '20 periods', this forms the basis for the standard deviation calculations, of which two standard deviations form the bandwidth as the defaults. Such parameters may require tailoring for any given market.
- The 'average deployed' should not be the best one for crossovers. Rather, it should be descriptive of the intermediate-term trend.
- If the average is lengthened, the number of standard deviations needs to be increased simultaneously; from 2 at 20 periods to 2.5 at 50 periods. Likewise, if the average is shortened, the number of standard deviations should be reduced; from 2 at 20 periods to 1.5 at 10 periods.
- The Bollinger Bands® are based on a simple moving average. This is because a simple moving average is used in the standard deviation calculation, and it is good to be logically consistent.
- Make no statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The sample size in most deployments of the Bollinger Bands® is simply too small for statistical significance.
- Indicators can be normalised with '%', by eliminating fixed thresholds in the process.
- Tags of the bands are just tags, not signals. A tag of the upper Bollinger Band® shouldn't be treated as a 'in-of-itself' sell signal. The same applies to a tag of the lower Bollinger Band®. It is not considered an 'in-of-itself' buy signal.
We hope you enjoyed our guide on Bollinger Bands and the best bollinger bands strategies. If you want to gain access to an even more comprehensive choice of indicators, why not take a look at MetaTrader 4 Supreme Edition? (MT4SE). This free MT4SE plugin not only grants you an extended number of indicators, but also offers an overall enhanced trading experience. Additionally, traders should consider using a Demo trading account first, in order to test the strategies they have learned in a risk-free trading environment, before using them in the live markets.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.