Bollinger Bands Lesson 2

Welcome to Bollinger Bands, part 2 with DailyFX education. In the first video we learned there are 2 common items a trader looks for in a good trading situation. First is to determine the direction of the daily trend. The second is to identify the best time to enter the trade in the direction of that trend. Bollinger Bands is a useful indicator that helps identify areas of support and resistance so a trader can open a position in the direction of the daily trend.

The most common setting for Bollinger bands is a 20 period SMA with 2 standard deviations. Since the Bollinger band is a volatility filter, most of the trading should occur inside the bands. Therefore, if prices reach the upper band in a down trend, we now have a resistance area to sell short into.

The opposite is true in an uptrend. If the prices reach the lower band, then we look for support to form and initiate a long position from that support. We can confirm the formation of support or resistance by waiting for a candle to close in the direction of the trend AFTER prices have pierced the appropriate band. Also, if you want to catch more conservative signals, then expand your standard deviations out to 3 so your setting would be a 20 period SMA with 3 standard deviations. Additionally, the volatility filter in the indicator can also forecast times of a potential breakout. We learned when Bollinger bands contract it indicates volatility is contracting as well. This means the bands tighten together and the distance between the upper and lower bands become smaller.

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Bollinger Bands Lesson 2

Many times, contraction of volatility precedes a breakout so we look for a break out in the direction of the trend AFTER we see a constricting distance between the bands. In this video, we will explore 2 new strategies of how to use Bollinger bands. These strategies use different input parameters and well discuss why it is important to our strategies. The first strategy will teach you how to use the Bollinger band as a trend and trade indicator at the same time. The second strategy will show what to do in trendless environments. Bollinger bands can identify when the market is trendless and indicate opportunities to trade. In both of these strategies, we will explore areas to place your stop and take profits. Although it helps to identify if the market is trending or range bound, what makes Bollinger bands versatile, is that you dont have to identify the market conditions yourself. You can let the Bollinger bands provide the market condition for you. Youll see what I mean as we explore these strategies further. Lets go ahead and get started The first strategy is for trending environments. John Bollinger, the creator of the Bollinger bands, provides 15 guidelines with regards to his invention. One of those guidelines states, Price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band. Therefore, if we can find opportunities where prices are continually striking the upper band, then it would suggest the prices are in a strong up trend. This guideline will become our basis for our trending strategy. And if you think about it, it makes sense because in strong trending environments, often times, prices will stay above the 20 period SMA in an uptrend and below the 20 period SMA in a down trend. Lets explore this theory out visually.

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Bollinger Bands Lesson 2

Lets assume prices are in an uptrend. John Bollinger suggested prices may continually strike and rub the upper band throughout the course of this up trend. You can easily find a situation on what this looks like. So how do we use Bollinger bands to alert us to trading signals? If you recall from the first video, traders want to be able to identify the trend AND identify the right time to trade in the direction of that trend. We can see in this example, if the prices are constantly striking our upper band, we can see that the trend is up. Now lets modify our input settings of the standard deviation to alert us when to get in and out of the trade. We are going to change the input parameters to include a 20 period SMA, but a 1 standard deviation. That way, if prices are rubbing against the upper band on a 2 standard deviation setting, then prices are likely to walk up on top of a 1 standard deviation setting. To enter a trade, we first identify the direction of the trend. With the EUR/USD being in an uptrend, we wait for a break above the 1 standard deviation upper band as our entry signal to go long. A successful break above the band occurred when a blue candle closed above the upper band. Then, we enter on the open of the next candle. Our initial stop is placed at the low of the breakout candle. Another way of stating the stop is the low of the candle just closed. The trader then looks for twice that distance to the stop as their profit target.

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Bollinger Bands Lesson 2

At times, this strategy is a mix of a breakout and trend strategy. Therefore, the break out candle is sometimes large and a wider stop should be used by the trader. In our money management videos, we discuss an alternative technique which would be appropriate when you have an unusually large break out candle. The technique is to move your stop to break even once you are half way to your target level. Let me illustrate this for you Here is an unusually large break out candle on this Bollinger band strategy. We calculate the distance from our entry to the low of the break out candle. That distance is how far we want this trade to move then we will move our stop to break even for a near risk less trade. In this case, prices did eventually retrace downward to our breakeven level and we would have been stopped out at break even. Notice how a couple of candles later, another break out with an unusually large candle to the upside occurred. Again that trader would have entered and eventually moved their stop to break even, and stopped out of the trade at breakeven or just about that level. So this 2 trade sequence would have yielded no profit which can be frustrating. However, with the wider stops used, the trader moved to a near riskless trade in both situations fairly quickly. Keep in mind that these various techniques have tradeoffs for using them. In this case, by moving your stop, you run the risk of getting stopped out early in the trade. Had we not used this alternative technique and stuck with the original strategy, our trade would have eventually hit the profit target before getting stopped out. In that case we would have made 1 trade for a 280 pip profit. So there is no perfect way of handling this strategy and you must recognize the tradeoffs you are making when modifying strategies. The second Bollinger band strategy is for range bound markets. Retail forex traders tend to do well in range bound markets as it can be easy to identify areas of support and resistance. However, if forex traders use a range bound strategy in a trending market, then they tend to experience more losses. The great thing about this Bollinger band ranging strategy is that the Bollinger bands help identify when the market is range bound. If the bands are not indicating a range bound environment, then simply stand aside from using the strategy. The standard deviations portion of the Bollinger band indicator is one the critical elements to this strategy. Youll recall from the first video that the Standard Deviation is a statistical term used to measure volatility. What that means to us is in times of high volatility, the bands move away from each other and in times of low volatility, the bands move close to one another. By definition, because of this volatility filter, the majority of the trading should take place between the upper band and the lower band. In this strategy, we will stretch out the length of the moving average used to encapsulate more price bars and data we will use a 50 period moving average with 2 standard deviations. Since we are looking for a ranging market, we want most of the data points to be between these two bandswe want to see minimal contact with the bands. One way to accomplish this is to look for the bands to be horizontal and parallel to each other. This means that over the previous 50 periods, the upper and lower bands have not changed much. Contrast this to a trending market and you can see the bands widen and trend with the prices.

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Bollinger Bands Lesson 2

We can see in this case of the EURJPY, how after an uptrend, the prices consolidate sideways into a ranging environment. The bands become horizontal and parallel to each other.

This indicates that price action is not making any significant head way in either direction. In our range trading video series, we discuss several range trading techniquesmake sure you check it out for other ways to trade ranges. But for this series, we are going to use the Bollinger bands to help us initiate range trading opportunities. Here is a specific example on the CHF/JPY. You can see in this example during the summer of 2009, the bands became horizontal and parallel. Most of the price action is contained within the bands with only a few candles and some wicks of candles poking outside of the bands. By the time September 2009 was upon us, a trader could have easily seen the range bound market developing. Since the direction of the previous trend was up, the trader will focus in on the lower band as an area for support and position ourselves for a long trade. This is because many times, during ranges, prices tend to eventually break out in the direction of the preceding trend. Lets discuss some trade examples more specifically, by focusing in on this area where prices reached the lower band.

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Bollinger Bands Lesson 2

For this ranging strategy, we will look to enter based on the pattern we discussed in video #1. So we look for prices to pierce the lower band, and then wait for a blue candle to print back inside the band. Our trade opportunity appears here so we open the trade on the next candle and place our stop just below the recent swing low. We use a 1:2 risk to reward ratio and look to take profit up here. Unfortunately we got stopped out of our trade. It seems fitting in this case, the same candle that stopped us out of the trade, actually closed back inside the lower band. As traders, these situations seem to appear more often than we would like. However, it is important to stick to your stop levels and wait for the next opportunity. So we enter again on the open of the next candle since this blue candle closed back inside the lower band as well. Again, we set our stop just below the low of this blue candle and take twice that distance as our profit target. This time the trade works out and our target is hit. Notice that in this 2 trade sequence, we incurred a losing trade, yet we still made a net of 160 pips. This is because of our money management using a 1:2 risk to reward ratio. We discuss this at length in our money management video, but it is worth repeating. When we are disciplined in our trade management, when we are right, our winners will outpace our losers as was the case here. So there you have it 2 additional strategies on how you can use the Bollinger bands in your trading and how it can be used in different market conditions. Since the Bollinger bands indicator has a volatility filter included in it, it can even provide clues to the current market condition. So if the prices are walking along the 1 standard deviation upper band, then the market is telling us prices are in relatively overbought levels. Prices can remain overbought or oversold for extended periods of time in strong trending moves. Or, if we stretch out our moving average and find most of the price action occurring inside the bands with the bands appearing horizontal, then the market is tells us there is no net progress in prices and we are in a range bound environment.

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Bollinger Bands Lesson 2

We hope you have found this video helpful. We invite you to attend our live webinars on Bollinger bands where our instructors will identify and locate trading examples in real time. It is also an opportunity to ask our instructors questions on this versatile indicator.

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