Posted on: 24 Oct, 2018
From the constellation of chart indicators available via the MT4 platform, no other comes as handy to assess the levels of volatility nor as popular as the “bollinger bands.” The inventor of the bollinger bands is a trader named John Bollinger.
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Have you ever wondered what’s the absolute ‘must-have’ component for traders?
Indisputably, I doubt nothing would come as high on the list as volatility. It is precisely through the magnitude of price gyrations that traders can expose themselves to the most suitable environment to find opportunities in the forex market.
So, how can we measure the different degrees of volatility in a market at any stage?
From the constellation of chart indicators available via the MT4 platform, no other comes as handy to assess the levels of volatility nor as popular as the “bollinger bands.”
The inventor of the bollinger bands is a trader named John Bollinger. As you can tell, he didn’t put much thought into coming up with the term. The truth to be told, it’s a rather amusing story how he came up with the term.
Back in the old days, John was interviewed by Bill Griffeth, an on-air host for the Financial News Network, who asked John how would he call his proprietary trading bands. Since that was a question John was unprepared for, he then resorted to what he refers in his website as the ‘alliteratively obvious choice’ of “bollinger bands.”
If you are interested in getting all the fine details behind the bollinger bands theory, its calculations, and much more feel free to check out John’s book, titled Bollinger on Bollinger Bands.
There is no much mystery behind these bands, really. But it’s precisely in its simplicity that resides its power. This trading indicator has at its core an 'n' period moving average with bands drawn at certain intervals above and below based on an applied standard deviation. The default settings include an 'n' value of 20 periods for the moving average and a standard deviation of 2. The upper and lower bands, therefore, represent in relative terms, whether or not the price is in overpriced or underpriced territory.
Soon thereafter, John Bollinger came up with a couple of new indicators as part of the bollinger bands suite. One is what’s referred to as the Bollinger Bands %b, which represents where price is in relation to the bands. The second one is called Bollinger Band Width, which simply illustrates how wide the bands happen to be.
Both indicators can be found in the chart above in the second and third window respectively.
I am a strong proponent in endorsing the understanding of market dynamics based on cycles. There are cycles in everything one can think of: Human cycles (pregnancy, infancy, toddler years, childhood, puberty, older adolescents, adulthood, middle aged, senior years), cycles in growing rice fields (land preparation, crop establishment, water use and management, the crop health, harvest, etc), you name it. Volatility is no different, it goes through cycles too.
We can break down volatility as a function of two universal principles: Expansion vs contraction.
In financial markets, since we are combining two sides constantly in dealings to find price equilibrium (buyers and sellers), these two complementary opposite forces facilitate the creation of movements that are, in relative terms, large or small in magnitude, depending on the imbalances of demand and supply. This creates expansion and contraction in price activity, which leads to certain degrees of volatility.
Thanks to John Bolliger and the bands he made popular more than 30 years ago, we now have a way to assess these levels of volatility in the market. Remember, volatility is the bread and butter for traders, hence when this indicator is properly applied, it can open up a new wealth of knowledge to exploit trade opportunities.
At its most basic level, when the market enters a quiet period, the bollinger bands go into contraction as a reflection of the plummeting conditions in volatility. By the same token, when the market experiences higher price activity, the bollinger bands go into expansion to represent the pick up in volatility.
In the chart below, I illustrate a distinction between the times when price contracts vs when it expands. The second window exhibits, via the %b, the times when the price is relatively overextended in relation to its 20-period moving average, which as I explained, is the midpoint of the band. In the third window, the BB width alerts us of how wide the bands are, which is in direct relationship with the increase in volatility as depicted by the compression and expansion of cycles.
There is a multitude of approaches that makes the bollinger bands a great tool to complement one's trading arsenal to help you spot trades. The ones I will list below represent only a paltry portion of the universe of strategies built around the bollinger bands but nonetheless do embody some of the most powerful I’ve come across.
One of the key principles behind the bollinger bands is that price tends to return back to its equilibrium or mean level. In bollinger band terms, that level is the 20-period moving average. Therefore, one of the uses of the bollinger bands is to enter at levels that are considered to be advantageous based on the latest price action.
This is a strategy that aims to get you filled at what's perceived as a low-risk entry level based on the recent price action. To qualify this trade, you must first determine what’s the underlying trend, only to enter with the momentum in your favor. Another precondition you'd find very powerful to keep you on the right camp is to only enter if the new swing high or low is greater in magnitude than the previous one as it clearly communicates a strong commitment is still in place.
To assess the magnitude of each cycle, you should use the bollinger band width indicator, as illustrated in the third window of the chart example below. If the BBW is breaking into new highs, that means the commitment to participate in buy or sell-side campaigns is on the rise, therefore, we’d be interested to enter if the price touches or moves outside the opposing side of the most distant bollinger band (low band in uptrends, high band in downtrends).
Another nuance to take into account. This is a trade that will be validated as long as we enter during a transition from expansion into contraction. We will avoid the phases of contraction into expansion. This is critical as we must avoid to expose ourselves in a context that is setting up to be more volatile against our ideal direction, which is what tends to occur when we transition from contraction into expansion.
In the example below, you are presented with an example on the EUR/USD in the 5m timeframe.
Similarly to the first example above, if you are looking to engage in a trend that is in motion yet you don’t expect the price to make it all the way to touch the other side of the bollinger bands, there is an alternative approach.
Instead of looking to reinstate your positions at what we've classified above as discounted prices (touch of the opposite side of the bollinger band), you could instead opt to get into the trade at what should be considered a fair price at the 20-period moving average.
The rest of the pre-conditions described in the first example above would still apply, with the only difference that this entry would be more aggressive in nature since the trader is willing to pay what's considered a fair price vs a discounted price.
A powerful chart pattern to exploit is what I call a trend exhaustion. To be able to enter this trade, one must first see a sequence of at least 3 pushes up or down, with each push showing a diverge between the price and the BBW. This type of move leading up to the eventual exhaustion is what I call ‘compression’.
As the price moves up, the magnitude of each push gets weaker. At this stage, what we then need to see is the price closing below the 20-period moving average to gather enough evidence that the market is done accepting higher prices and is ready to roll over to find the next level of equilibrium, wherever that might be.
If you are going to take this type of trade as part of your strategy, the most logical area to place you stop would obviously be above or below the point of the reverting cycle. It also goes without saying that this is an entry that should consider a multitude of other components before getting involved.
Remember, we are going through how the bollinger bands can help you to get you into the market. The levels you get filled at and the market conditions will be even more critical to the prospects of the trade succeeding.
The bollinger breakout trade indicates that when the bands get to contract, the next phase to develop is the expansionary one. In other words, when the bands squeeze together, sooner or later, there will be a release of energy (volatility) that tends to act like a rubber band or a spring.
If we find acceptance via a couple of closes outside the bollinger bands during a period of compression, the scenario is set up for a potential breakout.
One of the approaches to get you into the trade is the following. The moment that you notice a couple of closes outside the existing range, look to engage on a retest of the mid bollinger band (20 moving average). The stop could then be placed at the other extreme of the range, with a few pips of a buffer.
In the chart below, you can find an illustration on how a breakout out of a compression period plays out.
What characterizes this type of candle is the statistical anomaly it represents, hence why after the formation of this large-size trigger candle, we tend to see an immediate imbalance of demand or supply in the opposite direction. To spot this trade, you will need to add the ATR (average true range) in a new window.
This trade consists of identifying candles that are far larger in size than the ATR 14 period. The pre-conditions to validate the trade include a single candle that is at least 4 times larger than the ATR 14, and a close outside the bollinger band.
The trade tends to be safer if taken within the context of the underlying trend in higher time frames. It’s important to note that since the momentum is far from being in one’s favor when the trades get filled, one must be quick to either take the quick profits or at least move to break even.
You should expect the price to retrace at the bare minimum 50% of the distance from the large-size trigger candle, making this an ideal level in the chart to protect your position or cash out some of your profits.
At times, the price can go back all the way to the previous trigger candle open price, or even revert back all the way, as in the case of the first example. In terms of where to place your stop, you want to allow enough wiggle room, so an idea might be to use a stop loss size of equal distance to the large size trigger candle.
An early red flag that the trade might not be playing as one would expect would be if immediately after the entry you get a couple of candles closing below/above the trigger candle. That communicates that the market is not done yet, and that acceptance is being found, which would start defeating the purpose of this quick snap trade.
There is a second modality of the elongated candle can also be traded.
This time, it involves some tweaks to the pre-conditions. The large-size trigger candle only needs to be at least 2 times the size of the ATR. However, you will need to adjust the settings of the bollinger bands to 3 standard deviations vs the default value of 2. If you then spot a candle that closes outside the 3 standard deviation bollinger band, there you have your trade. Check the chart below as an example of this trade, which happens to be a statistical anomaly again.
In either case, there is an important caveat to be aware of. This type of trade will never be taken immediately after the breakout of a range. After we see a resolution outside a trading box, the expansionary wave tends to be impulsive in nature, which makes the engagement in a gift candle riskier. Allow the first wave outside a range breakout to run its course, and only then, as a second wave occurs, look to spot this trade.
You’ve made it to the end of this handy guide on the bollinger bands approach. You are now familiar with his creator, how the bands get calculated, what purposes they serve (measure volatility), along with different trading strategy examples that may be of value to your trading. It’s now time for you to practice some of the concepts laid out in this tutorial to find out by yourself how much value they may provide. The main point to take home should be that the bollinger bands are indeed a great technical tool to evaluate volatility in any market. As a result, it offers a blueprint to identify potential trading opportunities.
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