Saturday, July 16, 2011

The Proper Way of Using the Bollinger Bands


“Some people oversimplify things and think that the breach of the upper band is automatically a sell signal and the breach of the lower band automatically a buy signal. That, of course, is wrong…” – John Bollinger


John Bollinger, who was quoted in one of my past weekly trading updates, is a CFA (Chattered Financial Analyst) and CMT (Chattered Market Technician). His past and present achievements and activities in the trading world have made him unique and renowned. He’s developed a number of well-known analytical tools – above all the world famous Bollinger Bands.

For experienced traders, the Bollinger Bands need no introduction. However for the benefit of my readers: “…The default setting is 20-period moving average plus/minus twice the standard deviation,” says Mr. Bollinger. “In principle, this variation may of course be varied. Over the years I’ve found that in short-term trading, for example, it makes sense to choose a shorter moving average so that the Bollinger Bands are even more responsive to rapid changes in trend. For starters, however, the default setting is ideal and many traders go on to use it later as well.”

According to its creator, the Bollinger Bands have been generally plotted in charts since the 1930s. The emphasis here is on ‘plotted,’ so this was done for many decades by hand. For this reason, everything had to be very simple, because otherwise it wouldn’t have been possible and relevant to practical applications. However there’s one big problem with these simple bands: what percentage is the right one with this shift? So what’s needed here is a method for automatic standardization and scaling. Once more, the bands show relative reference points to determine whether prices are currently high or low.

In a recent interview in TRADERS’ magazine, John Bollinger refuted the popular way of using the Bollinger Bands. At the beginning of my currency trading life, I was taught to buy when the price hits the upper bands and sell when it hits the lower bands (plus how to interpret Bollinger bounce and Bollinger squeeze). This rule failed as many times as it worked. I began to wonder what went wrong.

Later I discovered that a currency trader would do better to follow the line of the least resistance. Unless one is taking a trading signal out of the Bollinger squeeze, it’s better and safer to take signals from the Bollinger Bands only in the direction of the overall trend. Counter-trend trading is particularly dangerous for currency traders.

Mr. Bollinger continues: “Traders can set the multiple by which standard deviation in the Bollinger bands are shifted up or down. I’ve chosen the multiple of 2, since this is the range of roughly 95% of all price movements within the bands. The higher the multiple chosen, the less likelihood there’s that one of the bands is breached. So apart from the multiple of standard deviation everything is automatically calculated, which means that it’s hardly possible any more for traders to ‘talk up’ the chart. In addition, the Bollinger Bands show, on a relative basis, whether the current price action is high or low. How to interpret this, is of course, another story.”

What does he mean by saying this? Below are some examples of the proper way of using this great indicator:

1. Since there are trends in the markets, as we all know, prices may be relatively high (uptrend) or relatively low (downtrend) over a long period of time. For this reason, the interpretation of the band is totally different, as the chart must be part of the context. So price reaching the lower Bollinger Bands within an established sideways market may be a good buy signal.

2. Given the context described above, the same signal within an overall downward trend may be a trigger for a momentum short trade.

3. Try to recognize the trend in the market and trade alongside it. For traders to recognize that there’s a trend market, they should consult additional indicators. The ADX (the Average Directional Movement Index), developed by Welles Wilder is particularly suitable for this. You can also combine the Bollinger Bands with the MACD (Moving Average Convergence Divergence), or with an indicator that shows the ascending slope of any moving average.

4. If the price in the Bollinger bands on a higher timeframe touches the lower band and you see an oscillator clearly diverging from the lows in the market price, a good opportunity is offered for a long trade.

5. When the market seems indecisive, of particular interest are situations in which a pair/cross with highly relative strength moves into an equilibrium zone and then breaks out again upwards within a small channel. Sometimes traders may watch the news, too. If the EURUSD, for example is currently ranging and positive news is being announced that doesn’t cause the instrument to rise or only slightly so, then a clean bearish signal has been generated.

I could go on giving you more examples, but I got limited time. You may search some historical data on some charts to confirm these facts. The most important thing is to take signals from the Bollinger Bands only in the direction of the major trend. And there are many ways of doing this.

NB: Please watch out for my coming articles with these titles: ‘Excellent Money Management Flexibility – Make the Best Choice!’ ‘Resist the Lure of High Risk – Part 3,’ ‘Carrying Out Stealth Raids in Weak and Strong Markets,’ ‘Worst-case Scenarios – Facts Are Sacred,’ ‘Effective Swing Trading in Forex,’ ‘Advanced Gap Trading – Trading with Insane Accuracy,’ ‘3 Recent Gap Trades,’ ‘Trading for a Livelihood – One of the Best Jobs in the World,’ ‘If I Were a Trading Neophyte…,’ ‘Developing the Right Attitude towards Losses - Part 3,’ ‘The True Holy Grail – The Long Sought for,’ ‘Achieve Success through Sensible Risk-to-reward Ratio (An Interview with a Trading Enthusiast),’ ‘ Clarifying Some Issues – Part 5,’ ‘Optimization of the USDCAD Hedging Strategy – Bringing the USDCAD to Subjection,’ ‘A CHF Breakout Strategy,’ ‘Overview of My Signals Strategies,’ ‘Is It Realistic to Give Guarantees in Trading?’ ’ ‘Monthly Trading Report (July 2011),’ etc.

This article is concluded with another quote from the creator of the Bollinger Bands:

“There are many different systems and ways that you can be successful. A real winner not only knows that, but also trades accordingly – every day. This is what most people cannot manage to do. So I believe that my big advantage is that I’ve been doing all this trading here for 31 years.”

Your questions and opinions are highly welcome.

Thank you.

With best regards,

Azeez Mustapha

Forex Signals Strategist, Funds Manager &Coach

Senior Analyst

FX Instructor, LLC


Yahoo! Messenger ID: saazalmu

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