How to Use Bollinger Bands

In previous articles I have referred to my “toolbox.” It is a journal I started writing in the beginning of my career 30-plus years ago. I recorded my many mistakes because I learn the most from them. But it also comprises lessons learned from colleagues, books and empirical research from the trading pits in Chicago. My toolbox is filled with the best parts of every new discipline I investigate. In this article I will share my favorite Bollinger Bands tips. Bollinger Bands can be used for trend and counter trading strategies.

How Bollinger Bands Form

They are plotted above and below a simple moving average. The recommended moving average is 20 periods, which represents an intermediate trend. The bands above and below the moving average are moving standard deviations (lower case sigma or σ). The bands vary in distance from the average as a function of market volatility. The bands are set at 2 standard deviations from the average. 1σ = 68%, 2σ = 95%, 3σ = 99%. The bands may be applied to any market or security. Any time frame may be analyzed, from daily, weekly, monthly charts or down to an intraday view.

Bollinger Band Signals

One of the primary uses of Bollinger Bands is to show whether prices are relatively high or low. In other words, they indicate when a market is overbought or oversold. The bands narrow during times of low volatility and expand rapidly when markets become volatile. Narrow bands are useful to option traders since option prices are heavily influenced by swings in volatility. Thus, neutral option strategies should be effective when the bands are too divergent. On the contrary, breakout strategies should pay when the bands are convergent.

Bollinger Band and Relative Strength Index (RSI)

Relying on one technical tool does not typically pay. All technical indicators have strengths, but none are effective all the time. Combinations of technical tools frequently increase confidence in trade decisions. Bollinger Bands and RSIs are a solid marriage. When price breaches the upper band and the RSI is above 70, odds favor a consolidation phase. Hence, neutral option strategies like iron condors and butterflies ought to work. This strategy should also work if the RSI is around 30 and the price is near the lower band.

Band Breach

When a band is penetrated it is a sign of trend strength. Though a period of consolidation is common when a band is violated it is also an indication that the dominant direction is intact and will soon resume.

Choppy Trade Tendencies

When a trend reaches exhaustion or attains overbought/oversold status, a consolidation phase often ensues. This is a phase where both bands tend to be support and resistance while the pace problem subsides. In other words, price gravitates to the mean or moving average.

Fundamentals move markets while technicals reveal the story and tendencies. Bollinger Bands work best when a market has moved too far, too fast or when it is wound too tight.

John Seguin, Market Taker Mentoring

Trader Education