Bollinger Bands were invented by John Bollinger. Used to confirm trading signals, normally from a Momentum Indicator , the bands indicate overbought and oversold levels relative to a moving average. Bollinger Bands are calculated at a specified number of standard deviations above and below the moving average , causing them to widen when prices are volatile and contract when prices are stable. Bollinger originally used a 20 day simple moving average and set the bands at 2 standard deviations, suited to intermediate cycles.
Microsoft is shown with 20 day Bollinger Bands at 2 standard deviations. Contracting bands warn that the market is about to trend: The first breakout is often a false move, preceding a strong trend in the opposite direction. A contracting range [C] is evident in June In a ranging market, a move that starts at one band normally carries through to the opposite band. A move outside the band indicates that the trend is strong and likely to continue. If price quickly reverses, however, expect a swing to the opposite band as with the quick reversal [QR] in early August.
A trend that hugs one band signals a strong trend that is likely to continue. Traders often wait for divergence on a Momentum Indicator to warn that the trend is about to end. When bands contract in a narrow neck, the squeeze is highlighted by a sharp fall in Bollinger's Band Width indicator as in the Microsoft [MSFT] chart below. The traditional way of trading the Bollinger Band squeeze is on breakout above or below the bands after a squeeze. Now Microsoft had been trending upward since and another advance was likely.
It is important to guard against fake signals in the opposite direction, like the one highlighted in mid-September The second strategy is a trend-following strategy I picked up from Nick Radge's book Unholy Grails , where he uses day Bollinger Bands to capture trend momentum.
The rules are simple:. Nick proposes setting the upper band at 3 standard deviations and the lower band at 1 standard deviation but I am wary of this too much like curve-fitting and would stick to bands at 2 standard deviations. Here I have plotted Microsoft with day Bollinger Bands at 2 standard deviations and week Twiggs Money Flow to highlight long-term buying and selling pressure.
The problem with momentum strategies is eye-watering drawdowns. Do not use this strategy to trade stocks when there is not a strong trend. Also, don't trade against the overall market. That is, don't short stocks in a bull market or go long in a bear market.
The default settings for Bollinger bands are 2. Edit Indicator Settings to change the standard settings. See Indicator Panel for directions on how to set up an indicator. Many investors follow active strategies but end up being reactive, rotating in and out of stocks at the wrong time.
Chaikin Volatility Developed by Marc Chaikin. Look for sharp increases in volatility prior to market tops and bottoms, followed by low volatility as the market loses interest. Twiggs Volatility Twiggs Volatility is a proprietary volatility indicator used to flag elevated market risk. A squeeze, where the bands converge into a narrow neck, often precedes a sharp price rise or fall.
Bollinger Bands Bollinger Band filters are calculated using exponential moving averages. Values are compared to Bollinger Bands at 1. Trading Strategies Bollinger Bands are powerful signals. Here are two great trading strategies: But first, let's review the key Bollinger Band trading signals. Trading Signals Microsoft is shown with 20 day Bollinger Bands at 2 standard deviations. Contracting Bands Contracting bands warn that the market is about to trend: Swings In a ranging market, a move that starts at one band normally carries through to the opposite band.
Breakouts and Reversals A move outside the band indicates that the trend is strong and likely to continue. Trends A trend that hugs one band signals a strong trend that is likely to continue.
The primary trend would alert traders to treat shorter-term bear signals with caution but it is also advisable to use Twiggs Money Flow to confirm buying or selling pressure. Here day Twiggs Money Flow is oscillating above zero, indicating buying pressure despite the downward breakout.
So the trade would be ignored. The subsequent pull-back to test support in November underlines the need not to set stops at the breakout level. Exit [red arrow] on bearish divergence on Twiggs Money Flow, when the second dip crosses below zero, or if price closes below the lower Bollinger Band.
Bollinger Band Trends The second strategy is a trend-following strategy I picked up from Nick Radge's book Unholy Grails , where he uses day Bollinger Bands to capture trend momentum. The rules are simple: Enter when price closes above the upper Bollinger Band Exit when price closes below the lower Bollinger Band Nick proposes setting the upper band at 3 standard deviations and the lower band at 1 standard deviation but I am wary of this too much like curve-fitting and would stick to bands at 2 standard deviations.
Exit when price falls below the lower band in Ignore the next possible long entry signal in April because Twiggs Money Flow signals a bearish divergence. Go long in October when price closes above the upper band. But the day's close is above the band, so this was not a valid exit signal. The olive green arrow in July , when MSFT closed above the upper band, is therefore not an entry signal as the October trade is still open.
Evaluation The problem with momentum strategies is eye-watering drawdowns. Setup The default settings for Bollinger bands are 2. The monthly What's New newsletter covers new articles on Trading and the Economy, as well as new software updates. Developed by Marc Chaikin. Bollinger's Bandwidth Indicator is used to warn of changes in volatility.
Bollinger Band filters are calculated using exponential moving averages.More...