What Is Bollinger Bands?
Before explaining how to use Bollinger Bands, lets see what kind of indicator it is, and how it looks like. If you don’t have Bollinger Bands on your chart, please add it now and let the settings be the default settings which is 20, 0, 2.
Bollinger Bands has three lines: Bollinger Upper Band, Bollinger Lower Band and Bollinger Middle Band.
Bollinger Middle Band is nothing but a simple moving average, but it is the base of the other two upper and lower bands.
Bollinger Upper and Lower Bands measure the deviation. The upper one is the maximum positive deviation and the lower one is the maximum negative deviation from the middle band. Therefore, Bollinger Bands as an indicator is a great tool to show the markets overbought or oversold condition. It is overbought when the price has moved up and formed the maximum deviation from the middle band, and it is oversold when the price has moved down and has the maximum deviation from the middle band to the bottom of the chart.
Under such a condition, overbought or oversold, there is the highest chance of forming the reversal signals. Weak reversal signals usually take the price to the middle band again, and then the price follows the same course again. Therefore, strong continuation signals form close to the middle band when the market is trending.
When the market is moving sideways, it usually goes up and down around the middle band and the upper and lower bands get close to each other to show the high and low of the price range.
As you see, Bollinger Bands can give you a lot of invaluable information about the markets condition.
As I mentioned earlier, the middle band is nothing but a simple moving average which is set to 20 with Bollinger Bands default settings:
20 simple moving average (SMA)
The upper band is the 20 x 2 standard deviation of the price added to the middle band:
20 SMA + (20 standard deviation of price x 2)
The upper band is the 20 x 2 standard deviation of the price deducted from the middle band:
20 SMA – (20 standard deviation of price x 2)
That is why Bollinger Bands is so strong in locating the trends and reversals. Combining the candlesticks patterns with Bollinger Bands, creates a great trading system that shows the strongest continuation and reversal trade setups.
In all the below examples, the Bollinger Bands settings is the default settings which is 20 period and 2 deviations. The sift is set to zero.
So, this is the Bollinger Bands default settings: 20, 2, 0
How to Use Bollinger Bands?
As this indicators gives you a lot of information about the price movements and the markets conditions, there are several different ways that you can use it in your trading.
1. Trend Trading:
One of the most important features of Bollinger Bands is that when the market is slow and there is no reasonable volatility, the upper and lower bands become close to each other:
As you see on the above chart, Bollinger upper and lower bands have become so close to each other where the white arrows show. Keep in mind that when the market becomes slow like that, and the price moves inside a narrow range, a breakout that can be the beginning of a strong trend, is on the way. You can easily guess the direction of the breakout with the signals that the market already has formed. Just follow the numbers at the above image and you will see what I mean.
The candlestick #1 has a long lower shadow. What does that mean? It means a big Bullish pressure is imposed to the market suddenly (several buyers have started buying). So the price wants to go up. This is the first signal. You could take a long position after this candle, but if you did not, the market would show you some more signals to go long.
After candlestick #1, market becomes slow and Bollinger upper and lower bands become so close to each other. Candlestick #2 shows a breakout with the Bollinger lower band, but it is closes above. This candlestick also has a long lower shadow that reflects the upward pressure. Then the market becomes slow for several candlesticks, BUT candlestick #3 assures you that the range is broken. So if you didn’t have a long position, you could go long at the close of #3 candlestick. Then some red candlesticks form, but you should know that after a range breakout, the very first reversal signal is not indeed a reversal signal. It is a continuation signal.
The above breakout could be the beginning of a big trend, but it didn’t form a trend actually. I just brought it here as an example of a tight ranging market and its breakout. If the candlesticks movements make you confused, you can shift to the line chart from time to time and find the real support and resistance lines/levels of the range. Line chart is plotted based on the close signal. Close price is very important specially when you want to interpret the Bollinger Bands signals and predict the market. Let’s shift to line chart and see how it looks like:
As you see the support and resistance of the range are shown much better in the line chart (blue circles). Numbers 1, 2 and 3 are where the candlesticks #1, #2 and #3 formed on the previous chart. In the above line chart, the range breakout is confirmed while candlestick #3 was forming because the price line goes up, touches and rides the Bollinger Upper Band. This means the price has broken above the range, and now we have an uptrend.
So we learned that the close price is very important when we work with Bollinger Bands. Bollinger Lower Band is not broken, as long as the candlesticks still close above, and Bollinger Upper Band is not broken, as long as the candlesticks close below it.
Like the Fibonacci system, one of the ways of trading using the Bollinger Bands, is finding a range and then waiting for its breakout.
Bollinger Bands are really good in following the trends. Please follow the numbers on the below chart.
#1 shows a good reversal signal (I will talk about the Bollinger Bands reversal signals later in this article). If I wanted to take a long position I would wait for more confirmation which is the #2 candlestick. I would go long at the close of #2 candlestick.
The next a few candlesticks break above the Bollinger Middle Band and the candlesticks after make a small ranging, BUT as you see all of them are closed “above” the Bollinger Middle Band (zone #3). Some of them tried to break down the Bollinger Middle Band, but they couldn’t. What does that mean?
It is another confirmation for the beginning of an uptrend. Zone #3 is the most important part of the below chart. Conservative traders prefer to take their long positions after the formation of such a confirmation. They go long when the price breaks above the thin red line (#4). They place the stop loss below the low of the last candlestick that its shadow is broken down the Bollinger Middle Band. As you see it goes up strongly (first red big arrow). There are some small red candlesticks but they should not be considered as reversal signals. At #5, the price goes down to retest the Bollinger Middle Band. This is the beginning of the second Elliott Wave. It is where some traders wait for the retrace (continuation) to go long. I have explained this here and here.
Can you take a short position at #5 ?
You can, but you’d better not to because it is against the trend direction. When you see the price has been going up strongly for such a long time, you should ignore the first and even the second reversal signal. They are not reversals. They are continuation signals in fact. I mean you have to consider them as continuation signals not reversals.
So the price goes down, retests the Bollinger Middle Band, and it even succeeds to break below the middle band, but keeps on going up again. As I have explained above, although it could break below the middle band, we should not go short.
It starts going up again (#6) and the next candlesticks all close “above” the Bollinger Middle Band. Fibonacci can be a big help here. As you see at #7 and when it wants to break above the 100.0% level, it shows a bearish reaction, but the next candlestick is closed above the Bollinger Middle Band and the next candlestick breaks above the 100.0% level (#8). We should now expect it to break above the 161.80% level, because it is a strong trend. As you see it could even reach the 261.80% level (#9) and break above it (#11).
When the uptrend is started strongly (#4) and when the 100.0% level is broken (#8), candlesticks touch and ride the Bollinger Upper Band. It is the same as when we have a downtrend. Candlesticks touch and ride the Bollinger Lower Band.
2. Reversal Signals Trading:
Bollinger Bands are great in showing the reversal signals too. Usually a nice reversal signal becomes formed when a candlestick breaks out of the Bollinger Upper or Lower Bands, and then it is followed by another candle which has a different color (the confirmation candlestick). One of the best examples can be seen in the above image at #1. Below, I am showing you the signal once again:
As you see the candlestick #1 which is a bearish candlestick is formed completely out of Bollinger Lower Band, and the next candlestick (#2) which is a bullish candlestick has covered the body and upper shadow and also most of the lower shadow of candlestick #1. These two candlesticks form a signal which is called Bullish Engulfing. A Bullish Engulfing that breaks out of the Bollinger Lower Band is much much stronger. A Bullish Engulfing is called Bearish Engulfing when it forms at the top of a bull market. It is a strong short reversal signal when it breaks out of Bollinger Upper Band. I strongly recommend you to learn the candlestick signals.
Here is some more reversal signals:
A long upper shadow that has broken out of the Bollinger Upper Band strongly:
Bullish Engulfing:
Note how both candlesticks broken out of the Bollinger Lower Band and how the second candlestick has covered the first one totally.
Dark Cloud Cover:
Note how both candlesticks have broken above of the Bollinger Upper Band and how the second candlestick has covered the first one. Also look at the big upper shadow that the second candlestick has formed.
Avoiding the False Signals
False signals always form. Indeed, the form a lot more than the true signal. True signals are easier to catch, because they are stronger and look outstanding.
There are false range breakouts and also false reversal signals. Those who like to trade the reversal signals, will be encountered with more false signals because a trend can be continued for a long time, and it is not easy to say when it will reverse. If you like to avoid being trapped by false reversal signals just ignore the very first two reversal signals when there is a strong trend ongoing.
If you really wait for the big and strong Bollinger Bands breakouts and you don’t rush to take a position when you see a weak and partial breakout, you won’t be trapped by the false reversals. For example, some traders take a short position when they see the below signal, but as you see this is not a strong signal compared to the signals I showed you above:
Why Is the above Signal Known as a False Signal?
1. The uptrend is really strong, and this signal is the very first reversal signal on such a strong uptrend. What do I mean by strong uptrend? Look at the uptrend slope. It is a sharp slope that is going up strongly. There is no sign of exhaustion in it yet. A trend has to show the exhaustion signals to tell us that a reversal is close.
2. Although about 50% of both #1 and #2 candlesticks have broken out of Bollinger Upper Band, this can not be considered as a strong breakout because
- Both candlesticks are not long enough and are relatively short.
- They don’t have any big upper shadow that reflects the power of a bearish pressure.
- The second candlestick is very short and it has not engulfed the first candlestick strongly.
Can you mention any more reasons?
Here is two other examples for such false reversal signals:
Can You Say Why the above Two Signals Are False?
The third signal is a relatively strong reversal signal, but the problem is it is formed when the uptrend was still strong and sharp. Look at the Bollinger Middle Band Slope (the first red arrow). So the trend is still strong and has not formed any sign of exhaustion when this relatively true signal was formed. You could take a short position, but you really had to get out when the continuation signal formed around Bollinger Middle Band.
Now look at the below chart and follow the numbers. Find out why some signals are false, some are true and some are continuation.
As you see Bollinger Middle Band works very well with the continuation signals when there is an ongoing strong trend. In an uptrend, continuation signals are formed when the candlesticks go down, retest Bollinger Middle Band, and then go up again. In a downtrend, continuation signals are formed when the candlesticks go up, retest Bollinger Middle Band and then go down again. Taking the continuation signals are much safer than the reversals, unless you make sure that the trend is really close to reverse and is already exhausted.
This was just an introduction how to use Bollinger Bands in taking the reversal and continuation trade setups on the trending and sideways markets. You need to practice more to become expert in locating the true signals. Learn more about Bollinger Bands:
source : luckscout.com
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