Bollinger Bands

Bollinger Bands are a technical indicator invented in the 1980s by John Bollinger, a now famous market technician. The indicator displays two bands plotted X standard deviations away from an X period moving average. The most common settings involve 2 standard deviations and a 20 period simple moving average (SMA). Thus, the most common Bollinger Bands shows two bands that are plotted two standard deviations away from a 20 period SMA. The chart below shows BBands with these settings applied to an Hourly chart of the EUR/USD.

How to use the Bollinger Bands?

How do you use the Bollinger Bands in trading? Different traders have different uses for the Bands. Some use them as a trend indicator, they buy when price goes above the upper BBand and sell when prices fall below the lower BBand. The most common use of the Bands however, is to use them as a mean reversion tool. When a financial instrument has moved far beyond the ‘’equilibrium’’ point, traders will use the Bollinger Bands to bet on prices ‘’normalizing’’. This involves buying at the lower BBand and selling at the upper Bollinger Band. Besides these common applications, the BBands indicator has many other uses, some of which we’ll cover in this entry.

Bollinger Bands Mean Reversion Strategy

Like we mentioned above, the most common use of the BBands is as a mean reversion tool. We buy at the lower Band and sell at the upper Band. The usual takeprofit area is the 20 simple moving average in the middle. While this strategy may sound simple and easy to execute, results can significantly deteriorate during market trends. This is also the reason why some traders prefer to use the Bands as brakeout points.

The chart above shows an example of Bollinger Bands with settings 20.2 applied on a EUR/USD Daily chart. Notice how price seems to be more or less ‘’contained’’ within the Bands and rarely travels outside of them. Here is that same chart with added entries and potential take profit targets.

We bought each time price broke below the lower Bollinger Band and sold on a price rally above the upper BBand. While 5 out of 9 traders were winners, the overall system didn’t do too well. As you can probably tell from the chart above, the winners were small while the losers were quite large. In conclusion, the fact that price was largely contained within the Bands didn’t matter. The Bollinger Bands are a volatility tool. If the market environment changes from a flat, ranging market to a trend, the Bands will adjust to still contain price most of the time. For example, we can see on the chart above that the last signal was a short. Not long after that, the EUR/USD rallied. It took a long time for the Euro to come back to ‘’normal’’ (normal = touch of the middle 20 SMA) and when it did, we were trading 45 pips higher than the prices at which we shorted! In other words, now the 20 SMA was trading 45 pips above the price marked by the past upper BBand.

If you want to use the Bollinger Bands as a mean reversion tool, keep the following tips in mind. - Use longer timeframe charts! The default 20,2 settings work better on longer timeframe charts. Or alternatively, increase the standard deviations to 3 or use a longer moving average in place of the 20 period simple MA - Use tight stoplosses! In our chart example above, we could’ve prevented some of the large losses during trends if we used tighter stoplosses. The scenario above let losses accumulate until the 20 SMA was eventually hit. - Use price action or common sense to judge when the market is trading in a range. This tip will be the hardest to implement as it requires substantial trading experience. If you’re new to trading, it would be best to try out this approach on a demo account.

Bollinger Bands Brakeout System

The second most common use for the BBands indicator is the complete opposite of the one presented above. This approach involves buying the brakeout above the upper Bollinger Band and selling the break below the lower Band. Look at the EUR/USD 1 Hour chart below.

We bought each time price rose above the upper Band and sold on every price move below the lower BBand. The stoploss was placed at the middle 20 simple moving average. Out of the 7 trades shown by the arrows on the chart above, only 2 ended up being winners. But surprisingly enough, despite the low hit rate this strategy managed to eke out a small gain. The 5 negative trades lost around 60 pips. The biggest win was +65 pips and the second largest take profit was +21 pips. This leads us to an overall positive result of +26 pips. Nothing to write home about, but not bad either. An added bonus of this strategy compared to the earlier mean reversion system is that the stoplosses here were much tighter. The SL in our earlier example was practically unlimited, if price just continues to rally and didn’t retrace at all, the mean reversion BB system could easily rack up serious losses on a single trade. This is why we recommended using a tighter stoploss.

Few caveats / tips are in order. While this strategy showed a profit in this particular time period, in my experience just blindly taking every signal on the 1 Hour chart is a quick road to the poor house. Just like with the mean reversion strategy, you will need to gain more chart reading experience and learn when to apply this system and when to stand on the sidelines. Another tip, while the mean reversion system would benefit from longer MAs and higher timeframes, the BB Brakeout performs better with shorter moving averages and on the lower timeframe charts.

Adding Price Action filters to Bollinger Bands

There are two main problems with the Bollinger Band approaches shared above. The first problem is that both approaches are mechanical in nature. All completely automatic systems tend to underperform trading strategies that incorporate some discretion. The second problem posed by these simple BBand techniques is that they are completely indicator based. If price hits the upper Bollinger Band, we sell (or buy for the brakeout system).

The Trendline and the Mean Reversion BB Strategy

By adding some price action to these methods, we can overcome these problems and hopefully improve our bottom line in the process. The first price action filter we’ll discuss is the simple yet surprisingly effective trendline. We will use the trendline to filter the signals generated by the mean reversion BBand system. Let’s use a chart to show an example of this in action.

This is the same time period on the EUR/USD 1 Hour chart we’ve used before, only this time we added a trendline filter for the entry in addition to the BBand touch. For a short, in addition to an upper Bollinger Band touch we’ll be requiring a break of price below the preceding ascending trendline. For a long signal, we’ll be needing a break of the descending trendline plus a touch of the lower band.

Comparing this modified version of the system to the original, we can see that the number of trades went down significantly from 9 to only 5, a decrease of almost 50 percent. In addition, all 5 trades shown on the picture above were winners, although some of them were very small. To avoid these small wins, you could try to avoid taking trade when the entry is very close to the 20 simple moving average in the middle. Another plus of the modified strategy is the decreased drawdown. In our earlier example, three of the trades had significant drawdown. Here, only one of the trades taken had a noticeable negative drawdown. As an added mod to this mod, the trendline also allows us to implement my suggestion number two from above: ‘’Use tight stoplosses’’.

The chart above shows the same example with added stoplosses above the most recent swing high / low. We were able to identify these turnaround points after the fact by using the trendline. Although one of the five trades switched from a win to a loss by adding a stop above the swing, the tighter stoplosses may perform better in the long run by preventing large runaway losses.

Horizontal Lines and the Bollinger Bands Brakeout Strategy

The second price action filter we’ll be exploring will be the horizontal line. We’ll be applying this PA filter to our simple BB Brakeout Strategy from above. As a small reminder, the BBands Brakeout system says to buy when price crosses over the upper Bollinger Band and sell when price goes below the lower band.

The chart above shows the same time period that we applied the Brakeout strategy to earlier. We just added a horizontal line filter on top. For a long, the price had to break above the recent swing high point marked by the HL in addition to touching the upper Bollinger. For a sell, we would look for price to touch the lower BBand AND break below the recent swing low. By applying this extra filter, the number of trades went down drastically from seven to three. Two of the trades were losers, one was a winner of 49 pips. The two losses lost 8 and 14 pips each. Adding it all up, the system had a performance of + 27 pips, better than the + 26 pips result without the filter. This might not seem like a big improvement, but the per trade result was a lot higher for this mod as the number of trades taken was a lot lower. The horizontal line showed a + 9 pips per trade result. This compares to a low + 3.7 pips per trade for the earlier simple brakeout strategy.

Mixing Systems - Moving Average Crossover filter

The moving average crossover ( click here for the the_moving_average_crossover_systems) is one of the trading strategies we have written about before. The system calls for buying when the shorter (faster) moving average goes above the longer moving average. A sell is initiated when the faster moving average goes below the slower (longer) moving average. Simple enough, so how do we mix these two systems together? Let’s start with the Mean Reversion system.

The MA crossover strategy we’ll be using is the 50 simple moving average for the faster MA and the 200 SMA for the slower moving average. On the chart above, you can see the 50 SMA shown in brown. The 200 SMA is colored black. At the start of the chart, a crossover to the downside occurs. This will be our filter. From now until the crossover reverses to the upside, we’ll only be looking at taking short trades and we’ll ignore any long signals. As can be seen on the picture, whenever price would hit the upper Bollinger Band we would take a short. We got 4 trade opportunities, 3 of which were winning trades. The single loser only set us back by 3 pips.

Now let’s see how this same time period would go with the Brakeout strategy discussed above. We’re still only taking shorts, but this time the entry signal will be at the lower Bollinger Band, not the upper. We’ll superimpose the Brakeout signals to the same chart to make it easier to compare them two. The brakeout signals and exits are marked in black on the chart below.

The brakeout strategy generated 5 signals during the same period, 4 of which were losers. The overall performance was also a loss. The main reason for this was the fact that after the MA crossover, prices didn’t really move much to the downside but instead slowly drifted lower in a downward sloping channel.

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