Bollinger Bands — Wall Street Favorite
500 years ago, people didn’t know that the Earth revolves around the Sun.
100 years ago, we couldn’t even dream of computers or smartphones.
20 years ago, traders had no idea that indicators might be more helpful for trading than people.
Technical analysis is rather art than science. It keeps developing because some traders are more perseverant than the others. One of the best examples of perseverant traders is John Bollinger, the author of Bollinger Bands tool.
– “How good is the indicator?”
– “Imagine that you are going for a hike. You need some equipment; you need some food and a tent. You may also need a satellite phone. Bollinger Bands will replace all this stuff and serve as a GPS on your way. However, you want to use this tool when trading, not when camping”.
John Bollinger developed this indicator in 2001. He also published a book about it. Bollinger Bands tool has been around for almost 20 years, but traders keep reinventing it. The tool has so many nuances that Bollinger himself doesn’t know it 100%!
Why would I need this tool?
There are tons of applications. If you have a hard time:
- defining a trend;
- finding the right trade entry point;
- distinguishing between a flat and a trend;
Bollinger Bands could be the answer. It is a panacea that can be applied in any market: Forex, commodities or cryptocurrencies.
Why should I trust a technical indicator? I read that everything is reflected in the price.
When it comes to books on technical analysis, one of the first things we learn is that “everything is reflected in the price”. Sounds good, right?
This phrase means that:
- Indicators don’t work and you shouldn’t rely on them, because: a) they lag behind the price and b) they are based on math.
- The only way to success is to learn how to read the price. Everything else is unnecessary.
Beginners tend to idealize this stereotype. They like the idea that technical analysis is all you need when it comes to trading and that all the other approaches are wrong:
- Fundamental analysis was developed by nerds. How can economics predict people’s behavior?
- Indicators don’t work: formulas lag behind the market. Since indicators don’t work, you should get rid of them.
Bollinger was familiar with these ideas. However, he didn’t want to be limited with only the price. John combined technical, fundamental and indicator analysis in trading.
Bollinger called his approach “rational” trading. To trade using only technical analysis is like drink only water: you will hardly survive.
While the price may take into account all the factors, the trader may not. It’s just impossible. Even after years of practice, you will still make mistakes.
Therefore, there are no bad tools in trading. Do not limit yourself. Learn new tricks.
Be flexible. Use those indicators that you like. You could take the following ones:
- moving averages to identify trends;
- RSI to detect divergence;
- stochastics for flats.
Just be careful. Don’t use more than 2 indicators at a time.
Use the bands
Bollinger Bands look like a writhing snake or a worm. The price is surrounded by an envelope:
The indicator reflects volatility — the power of price movements. When the bands narrow, the trend weakens and turns into a flat.
And vice versa: when the bands expand, the market accelerates; the flat turns into a trend:
The indicator is based on the following formula:
- The middle line is a 20-day moving average, SMA 20.
- The top and the bottom bands represent a displaced moving average, DMA 20x2.
Strength is not king
Bands can be used not only to estimate volatility, but also to identify a trade entry point. This tool works better than any advisor out there!
John suggested that 90% of all the price movements in the market represents noise, and this noise doesn’t lead to profit. At the same time, the price will not break through the indicator channels.
When the price breaks through the bands, we get a signal to enter. The price reaches a critical point, and we start waiting for a turn towards the indicator’s center:
This approach is referred to as “return to average”. It has 2 stages:
- The price moves within the channel, closer to the middle line. Market noise;
- The price gains momentum to break through the channel. However, it fails to do so and returns to the moving average.
The price reaction to the indicator is similar to the law of universal gravitation. No matter how hard you jump, you will be pulled back to the surface.
Gravitation predictability is good for people. We walk and are not afraid that we will fly into space. The price reaction for Bollinger Bands is also quite predictable, which means you can make money using this tool.
Gravity is more reliable than the indicator, as the indicator may not work sometimes. What should I do?
Bollinger’s “gravity” works only in flats. When the price reaches the bands’ border within a trend, this may be a sign of consolidation. Which you must ignore:
Therefore, we create two checklists:
- the first one is to identify flats;
- the other one is to identify market entry points.
The checklists will serve as our trading system. Also, they will help us filter out bad transactions.
Flat test
The easiest way to identify a flat is to look at the chart from left to right. In a flat, the price moves in the form of a V-shaped line, while the Bollinger bands narrow:
If you use a candlestick chart by default, you will definitely be inclined to start analyzing it, which may be distracting. Therefore, you should switch to a line chart to avoid focusing on each of the candles.
Another tip: look at the indicator moving average. It defines the trend. If the price chaotically crosses the line up and down, the trend will turn into a flat:
Once you’ve identified a flat in the market, mark a supply and demand zone on the last swings, as shown above.
Don’t draw flats wherever it seems like the right thing to do. If the trend has updated the minimum or maximum levels, there is no flat:
Now that we’ve covered the basics, let’s organize the information in a checklist. Practice using a demo account ASAP:
- Don’t make things too complicated. Look at the chart from left to right. Switch to linear mapping if you want to “read” the candles.
If you are not sure of the trend:
- The price is moving in the form of a V-shaped line;
- Trend impulses are equal;
- The price has crossed the Bollinger average more than twice.
And now let’s practice:
All requirements are met. Note that the flat started at point 2.
After passing point 4, the price went up.
Let’s open a transaction
We have identified a steady flat. Now it’s time to open a transaction:
- according to the general trend based on the daily chart;
- from the flat border, in the demand / supply zone;
- on a candle that breaks through the indicator and then returns inside.
Here we go:
The general trend was upward; the price reached the flat support. The candle broke through the lower Bollinger band and then returned inside. We opened a transaction.
How many times should I enter within one flat?
Just once. After some practice, you will be able to trade against the trend. However, you should never enter one flat more than twice.
Bollinger could do it. You will too.
Traders use the bands everywhere. They use them in flats. They use them both but in and against trends.
If you use checklists and practice regularly, you will eventually stop trading haphazardly.
Make more mistakes! It may take you 30 minutes to understand a concept, but you won’t become a successful trader until you make at least 100 transactions.
Do you know the difference between a trading master and a newbie? The former made 1000 mistakes, the latter — just a few.
We know you will succeed. How about some practice now?
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