Created by market technician John Bollinger in the 1980s, Bollinger Bands (BBs) are a favored indicator for many traders worldwide. According to Bollinger, BBs are intended to answer one simple question: Are prices high or low on a relative basis?
To address this inquiry, Bollinger Bands view volatility as being dynamic. Thus, they’re designed to be an “envelope” of evolving price action. Each set of BBs consists of an upper band, lower band, and midpoint―the parameters by which price is contextualized.
So how is a Bollinger Bands strategy traded in the live market? It’s used in three distinct market states: trend, breakout, and rotation. Let’s take a look at one BB strategy for each of these situations.
1. Using BBs to Trade Trends
A trend is a periodic, directional movement in price action. Trends occur on all time frames, including intraday, day, week, month, and yearly horizons. Bollinger Bands help traders spot trending markets in two ways:
- Wide bands: An extended or “wide” distance between the upper and lower bands suggests greater pricing volatility. Wide bands indicate that trading conditions are ideal and price is on the move.
- External close: A periodic close above an upper band or below a lower band suggests that trend extension is likely. This is a user-friendly signal when applying OHLC or candlestick charts to price.
If you’re using a Bollinger Bands strategy to trade trends, then it is important to observe the distance between bands and where pricing bars are closing. To illustrate, let’s say that springtime Midwest flooding has triggered a daily uptrend in CME December corn futures. To get in on the bullish trend, a trader could use BBs as follows:
- Observe the width between the upper and lower bands. Extended bands signal enhanced pricing volatility and ripe conditions for trend extension.
- Wait for December corn to post a daily close above the upper band. When this event occurs, place an order to buy December corn. Stop loss orders may be placed beneath Fibonacci retracement levels, the BB midpoint, or the previous day’s or week’s low.
2. Trading Breakouts with BBs
One of the best things about BBs is that they can help traders with market entry. As it pertains to spotting breakouts, or unexpected moves in price, they’re especially useful in getting in on a sudden directional move ahead of time.
In contrast to the wide-open appearance of trending markets, BBs signal a pending breakout by exhibiting a reduced bandwidth. Essentially, when the upper and lower bands are “tight,” a market is becoming compressed. When price breaks outside the BBs, a substantial directional move is possible.
Assume that June WTI crude oil futures are trading in an extremely tight fashion ahead of the weekly EIA inventories report. In reference to the 30-minute chart, WTI’s price has an upper BB of $50.00 and a lower BB of $49.25. You could trade a breakout by using the following Bollinger Bands strategy:
- Observe price action for tests and rejections of either the upper or lower band. Generally, the more rejections of a level, the greater its relevance.
- Upon the occurrence of multiple failed tests, a buy or sell may be worthwhile. To execute one, a stop market or stop limit buy-sell order may be placed at $50.01 or $49.24.
- Because of the short time frame, stop losses and profit targets are best kept moderate. Using a 1:1 or 1:2 risk versus reward ratio or momentum scalping with multi-bracket orders are two potential ways to manage risk.
3. Capitalizing on Rotational Markets with BBs
A rotational market is one that has no direction and is “range bound.” BBs are ideal tools for identifying range-bound products. Reduced or “tight” width between the upper and lower bands signals market consolidation.
Trading rotational markets with BBs is essentially viewing the outer bands as support or resistance levels. In practice, a trader simply takes a position opposite of price action from these levels in anticipation of reversion to the BB midpoint. Assuming our WTI scenario from above (upper band at $50.00 and lower band at $49.25), this may be accomplished via the following Bollinger Bands strategy:
- Enter sell orders at $50.00 or immediately below $50.00.
- Enter buy orders at $49.25 or immediately above $49.25.
- Implementing conservative profit targets and stop losses is the best way to trade rotational markets. In addition, applying risk to reward ratios at a minimum of 1:1 is a good rule of thumb.
Want to Add a Bollinger Bands Strategy to Your Trading Plan?
One of the benefits of Bollinger Bands is that traders can apply them to any product, time frame, or strategy. However, before jumping into the market with BBs, building a rock-solid technical knowledge base is a must.
To learn more, check out Daniels Trading’s online guide 10 Rules for Technical Trading. In it, you’ll learn the 10 key directives that help successful market technicians prosper.