Trading with Bollinger Bands

Tuesday, August 21, 2007

WHAT IS?

Bollinger Bands are a technical analysis tool invented by John Bollinger in the 1980s. Having evolved from the concept of trading bands, Bollinger Bands can be used to measure the highness or lowness of the price relative to previous trades.

Bollinger Bands consist of:

1. A middle band being a N-period simple moving average
2. An upper band at K times a N-period standard deviation above the middle band
3. A lower band at K times a N-period standard deviation below the middle band

Typical values for N and K are 20 and 2, respectively.

The bands cannot, as some have supposed, be used to make reliable statements regarding what fraction of an equity's prices will lie within a certain distance of the mean value. This is because an individual equity's price does not obey known distribution functions (see stochastic process). For example, if the bands for plus or minus two standard deviations (2SD) are computed, it is wrong to suppose that ~95% of an equity's closing prices will, on average, lie within the Bollinger bands. That would require, among other things, that the prices be normally distributed, which they are generally not. It would further require that the true standard deviation be known. The standard deviation calculated as above, however, is only an uncertain estimate of the true standard deviation. Furthermore, it should be realized that the "standard deviations" of stock prices for finite time periods are not fixed parameters as required to apply classical statistical theory, but instead are variables in constant flux depending on price volatility. The bands give a visual picture of a stock's price volatility. Nevertheless, the bands can be useful in the technical analysis of prices or returns and by Chebyshev's inequality contain at least 75% of prices. These occurrences should be considered in relation to other factors before making investment decisions.

It is of interest to note that faulty interpretation of a price touching or breaching a band based on incorrect statistical assumptions has become so widespread that some traders now use these events alone as trading signals and by so doing may have unwittingly injected significance into these band-touching events that should otherwise be absent. Nevertheless, anyone can observe over time, that for a diversified group of mutual funds, say, the proportion of daily adjusted close prices that breach their 1-month 2SD Bollinger bands varies between 5% and 15% of days, with each fund having a fairly constant, characteristic long-term breach probability descriptive of its long-term, relative volatility.

When the bands lie close together a period of low volatility in stock price is indicated. When they are far apart a period of high volatility in price is indicated. When the bands have only a slight slope and lie approximately parallel for an extended time the price of a stock will be found to oscillate up and down between the bands as though in a channel.

The use of Bollinger Bands varies wildly among traders. Some traders buy when price touches the lower Bollinger Band and exit when price touches the moving average in the center of the bands. Other traders buy when price breaks above the upper Bollinger Band or sell when price falls below the lower Bollinger Band. Moreover, the use of Bollinger Bands is not confined to stock traders; options traders, most notably implied volatility traders, often sell options when Bollinger Bands are historically far apart or buy options when the Bollinger Bands are historically close together, in both instances, expecting volatility to revert back towards the average historical volatility level for the stock.

HOW I USE IT

I use 2 Bollinger Bands with the same value on my technical charts. These 2 BB are for:

1. Trend Reversal Detection
2. Exit Target
3. Entry Point

Before we go on any further, a visual display is needed since we human learn faster through our visual.



As you can see in the graph, there are 2 BB with RSI. There are 5 set of circle indicating when the price cut thru Bollinger Bands. I will try to explain here according to numbers in the chart.

1. Price cut the upper BB at the same time RSI only cut thru middle band. Indicating the price is over bought while RSI is showing weakness. That is your point to short.

2. Price cut thru the lower BB and RSI is doing exactly the same. This showing that the price is according to strength. Exit at will. This also indicates a new trend has started. Take only short position from now on.

3. Same as no.2, this is your exit position. RSI agrees with the price. Continue to trade short.

4. Price cut thru the lower Bands but RSI is in the upper part of the Bands. This is a sign to start thinking of reversal. Lowest price at that point was 1.0550. Normally I would give out signals based on that lowest price.

5. Price makes a new low of 1.0530 and RSI still disagree with it. This is due to last minute trend traders who are pushing the price even lower thinking the trend is still there. I must agree, the trend is still there but the strength is gone long ago.

If I were to trade this pair, I would give out a signal to long @ 1.0550. The price hit bottom at 1.0530. Meaning there was a -20 pip position hold. Now the position is +30 and guess what. Its breaking the middle bands. Once the middle bands is broken and it cut thru upper bands and RSI agrees with it, we have ourself an uptrend. Meaning that I have trade the pair much earlier than most traders do because they are trading on trend.

At the time of writing I am holding ucad long with SL at breakeven. The worse thing that could happen is ucad reverse making a new low leaving me with nothing. If all goes well, I would like to see that upper band and make my exit there.

Of course there is no certainty in forex. In this article I am only showing the possibilities of using only BB and RSI to trade forex. Currently I am using 4 indicators to my technical analysis. Maybe some of you out there can do much better and come up with a better system.

Update:

As you can see in the picture, those circle are my entry and exit point. At the time of writing, I have already closed 2 position with +97 pip and holding 1 position with SL at +8 pip. Thats brings a confirmed total of +105 pip for ucad alone.

Looking at the chart, Ucad is still a long trade but there is not much follow thru. This maybe to the fundamental effect saying usd dollar has been so weak all this while making trader unwilling to enter on usd side.