Trading Bollinger Bands

Wednesday, 30 March 2011 02:12

Bollinger Bands are one of the most popular technical indicators traders like to use. There are many strategies built entirely around them. In this article we will focus on the squeeze and breakout strategy.

Bollinger Bands work by drawing a “band” which is formed by two offset simple moving averages that enclose the price. The offset which separates the movinga averages is a function of the price’s standard deviation. The moving average period determines the smoothness of the bands.

There are two main ways to trade them.

The first is based on the fact that the price can bounce off the bands. Whenever the price reaches the upper band, we consider it to be overbought and initiate a sell order. On the opposite, when the price touches the lower band, the price is oversold and we can open a buy order.

The problem with this method is that the price often “walks” along the bands instead of bouncing off and depending on the markets you are trading this can be a losing strategy.

This is why we prefer the second method.

Trading Bollinger Bands Breakouts

The second method of trading Bollinger Bands is going with direction of Breakouts. This consists on waiting for the Bands to “squeeze” and the price to suddenly to jump out of the bands creating a “choking” effect.

In this situation, the price is likely to continue in the same direction as the breakout. This strategy has the advantage of forcing you to trade in the same direction as the market momentum instead of trading against it.

You can include a second Bollinger Bands setup with a different standard deviation. A general setup is to use 1 and 2 as your standard deviation values. Then you can observe the price “walking” within the two outer bands and use that as a guide to close your open positions.

In all cases, it is important to set a stop loss level. Typically this will be placed right above or below the latest inflection point.

This concludes our overview of the Bollinger Bands technical indicator. We recommend that you experiment with different currency pairs or trading periods in order to find the situations in which you are the most comfortable. You can also use this strategy as an additional element of a larger trading system.