Most traders often make erroneous decisions about trading amid volatilities. Due to the failure of classic analysis, traders have faced challenges in determining when a precise trading opportunity will arrive; thus, confusion usually overpowers profits, resulting in the continuous quest of successful indicators that clearly and firmly guide the way out to a clear understanding in identifying trading opportunities.
Platform: In this article, we will discuss the powerful tool known as Bollinger Bands which can help traders judge volatility, find trends and discover potential breakouts. With an understanding of Bollinger Bands and practical applications, traders will learn how to improve strategies in making more informed decisions.
Solution: In the following pages, you will find three practical trading strategies based on Bollinger Bands, backed by thorough backtesting and robust data. Let’s have a look at these!
What Are Bollinger Bands?
The Bollinger Bands was devised by John Bollinger. The three lines in the Bollinger Bands are as follows:
- Middle Band: It is normally a Simple Moving Average (SMA) of 10-days.
- Upper Band: This is found by taking two standard deviations from the middle band.
- Lower Band: This is obtained by subtracting two standard deviations from the middle band.
The bands change in width as volatility changes in the market. The bands spread out more when volatility increases. Lower volatility is represented by narrower bands. Traders generally make use of the bands to identify overbought and oversold levels. The price’s location in the bands does not, however, form the basis of a trading decision in itself.
Common Mistakes
In particular, traders commit a crucial mistake when entering the position based on touching the price by outer bands with lack of attention to trend, a potentially very dangerous activity especially at high volatile markets.
Strategy 1: Mean Reversion with Bollinger Bands
Rules
- Buy – the closing of price when the price has gone under the lower Bollinger Band 2 standard deviation under the 10-period SMA
- Selling: When the price close over the 10period SMA.
Backtest Result
Using this mean reversion strategy on the S&P 500 results in the following equity curve:
Annual Return: The strategy returned around 9% annual returns, just about a percent lower than buy-and-hold return.
Time in Market: Strategy was invested only 25% of the time.
Win Rate: This is a pretty good strategy with win rate around 76%.
Conclusion
This strategy allows traders to cash in on price reversals; when the market is over-sold, they purchase and sell when it starts bouncing back.
Strategy 2: Bollinger Band Squeeze
Trading Concept
This is a situation where Bollinger Bands contract-this implies that the market experiences low volatility and is hence prone to an explosive movement of prices.
Rules of Trading
- Entry Signal: In case the price breaks through the upper band after experiencing a squeeze, enter into a trade.
- Exit Signal: The price closes below the lower band.
Backtest Results
Backtesting squeeze strategy on Pepsi Cola produces the following:
Annual Return: About 12.5% that trails the buy-and-hold strategy.
Trade Frequency: Only 81 trades since 1960 are reported, which suggests that this is a disciplined strategy.
Drawdown: This strategy experienced a maximum drawdown of 26%, which is quite in favor compared to a buy-and-hold strategy.
Conclusion
Although this strategy is somewhat profitable, its performance is somewhat volatile asset-to-asset, revealing the impact of asset selection on trading.
Strategy 3: Trend Following with Bollinger Bands
Rules
- Long Entry Signal: Buy at the break above the high Bollinger Band
- Short Exit Signal: Hold the long position until the close below the low Bollinger Band
Backtest Results
Using this trend-following strategy on the S&P 500:
- Annual Return: A relatively conservative 4% return, reflecting the risk averseness for capturing market trend.
- Investment Time: Traders are invested approximately 56% of the time.
- Drawdown: Relatively to buy and hold strategies, it reduces drawdowns.
Conclusion
The idea of riding trends in bull markets is relatively efficient; however, returns could be small in flat and bearish conditions. Trading is a game of risk management.
Advantages and Disadvantages of Bollinger Bands
Advantages
- Ease of Interpretation: Bollinger Bands are easy to interpret and apply, which makes them accessible for all skill levels of traders.
- Volatility Measurement: They effectively measure the market volatility, helping the trader understand the potential price movements.
- Trend Indication: The bands can help in indicating trends, which provide an opportunity for timely entries and exits.
Disadvantages
- False Signals: The indicator may give false signals, especially in choppy or sideways markets.
- Asset Sensitivity: Bollinger Bands function differently on different asset classes and require adjustments in the light of market conditions.
- Over-Reliance: The reliance of traders on Bollinger Bands without considering other indicators can lead to more significant drawdowns.
Conclusion
Bollinger Bands can be a critical tool for trend identification and volatility measurement and proper strategy execution. However, there are still many people getting caught up in the fallacy of overreliance. Always make sure you change your approach to the type of asset class you’re trading.
So to summarize, we covered three practical Bollinger Band trading strategies that improve your ability to trade better. Do not forget to backtest those strategies and fine-tune them to your trading style and your risk tolerance.
Stay tuned for our next video as we introduce you to another very useful trading indicator. For more insights and resources, visit our website at where you enjoy hundreds of free trading strategies. Happy trading!