Bollinger Bands have been used to measure market volatility for several decades. John Bollinger created them in 1980 as a way to measure market volatility and predict possible price surges to give traders an advantage.
Bollinger Bands measure market volatility to help define an appropriate entry or exit point for a trade. Look for opportunities to use Bollinger Bands to create a profitable trade. Chowdown will help learn about Bollinger Bands and how to trade them.
Before learning the trading strategy that can be used with the Bollinger Bands indicator, learn what the indicator is made of.
How To Use Bollinger Bands
Three lines represent a Bollinger Band:
1. Middle Band: A moving average that is 20 times the market price.
2. Upper Band: The market price plus two standard deviations.
3. Lower Band: The market price minus two standard deviations.
Standard deviations automatically adjust based on how much the prices are moving. This means the standard deviations will expand during times of high volatility and will stay small during times of low volatility. This is how the Bollinger Bands are able to provide a unique way of detecting a breakout in the market.
Understanding “The Squeeze”
The main idea of how to trade using the Bollinger Bands is based on a principle called “The Squeeze.”
When the top and bottom band of the indicator get very close to one another, this means that there is very low market volatility in that area. When that happens, do not be tricked into thinking that the market will stay this way for long. Usually, what follows low volatility is a period of high volatility.
Trader’s Pro-Tip: Springs are a very useful analogy for a Squeeze. A tighter band means more energy is being stored, and the impending breakout is more likely to be a big one.
Trading the Bollinger Band Breakout
There is much more to a successful Bollinger Bands strategy than just buying when the price meets one of the lines. It involves a lot of waiting for the right signal. Here is a breakdown of the process for identifying a breakout and trading it.
Step 1: What is a Squeeze?
You can identify a squeeze with 'tight' bands with a specific number of candles. Depending on the time frame of the chart, the period of time will differ. For example, 2 weeks on a daily chart, or 2 hours on a 15-minute chart.
Step 2: What is a Breakout Candle?
- A breakout signal will occur when a candle closes beyond the bands.
- A candle that closes above the Upper Band will signal a bullish breakout.
- A candle that closes below the Lower Band will signal a bearish breakout.
Step 3: Confirm With Volume
A low-volume breakout is more often than not just a fakeout. A good trading strategy is to only trade breakouts that are accompanied by a significant volume increase. This is because it is evidence to the fact that institutional 'big money' has traded behind the movement of the price.
A More Complete Strategy With More Indicators
To avoid only using a single technical analysis indicator, there are a number of indicators that can be used to prevent getting the signals filtered out, and which are used by a number of professional traders that use Bollinger Bands.
Relative Strength Index (RSI): If an RSI indicates bullish divergence when the price breaks above the Upper Band, the breakout will be seen as a failed breakout.
MACD: Use a directional MACD crossover trend for added momentum in the direction of the breakout when a MACD crossover occurs.
Comparing Trend Following and Bollinger Squeeze Strategy
|
Feature |
Bollinger Squeeze |
Trend Following |
|
Market Condition |
Low Volatility / Sideways |
High Volatility / Trending |
|
Goal |
Catch the start of a move |
Ride an existing move |
|
Risk |
False breakouts (Fakeouts) |
Entering too late |
|
Primary Tool |
Narrowing Bands |
Sloping Moving Averages |
Risk Management
Trading breakouts is exciting but high-risk. Prices frequently "retest" the breakout zone before continuing.
Stop Loss Placement: For a bullish breakout, your stop loss should be placed just below the Middle Band (the 20 SMA). If the price reverses and breaks below the middle band, the breakout thesis is likely dead.
Take Profit: You may exit when the price contacts the band opposite or when the bands begin to flatten, which indicates a momentum fade.
Avoiding Common Mistakes
1. Foreseeing the Breakout: Avoid buying inside the squeeze because of a "gut feeling" that it will break upwards. Wait for the band to close above it.
2. Ignoring the Overall Trend: When breakouts occur in the overall trend's direction (e.g., bullish breakouts during an overall bull market), they experience a higher likelihood of success.
3. Using Default Settings Everywhere: Although 20 periods and 2 standard deviations are considered standard, certain markets (such as the highly volatile Crypto markets) may need to take more deviation from the norm in order to avoid market noise.
Final Thoughts
The Bollinger Bands indicator is one of the best tools for trading because it is always changing to fit the market. When you learn Bollinger Bands breakout trading, you learn to stop chasing the market and instead wait for the market to give you its next big direction.
The Bollinger Bands strategy is about having control. The Squeeze indicates the market is about to shift; the breakout indicates the direction in which the shift will occur; and your control is about how much you will keep.
Do you want me to develop a specific trading checklist or cheat sheet for distinguishing “Fakeouts” from true breakouts?
DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.
DISCLAIMER: This blog is NOT any buy or sell recommendation. No investment or trading advice is given. The content is purely for educational and information purposes only. Always consult your eligible financial advisor for investment-related decisions.
.webp)
