Do you want to know how to build winning trading strategies? If your answer is yes, then this article series is just what you need. While there is no single strategy that is the best (like there is no best tool or house or car) there can be a strategy that is the best for you!
How to trade with Bollinger Bands, part I
Bollinger bands help in creating structure and maintaining the necessary discipline so that the trader doesn’t enter his or her orders just as the big players are trading against him or her. At the end of the day, trading is about finding ways to participate in the price moves that are generated by institutional traders and this is where Bollinger Bands can help us.
The bands are created by adding and subtracting e.g. two standard deviations from the base and plotting a line above and a line below it. The base could be any moving average but the standard setting is often 20-periods. Without going too much into the mathematics, it is sufficient to say that the bands are further away from the base (or the mean) when volatility is high and closer to the base when the market is less volatile.
Let’s take a look at some of the applications for the bands.
Reversals during sideways markets
The first question all traders should ask is whether the market is trending or ranging. If the highs and lows are equal it’s clear that the market isn’t trending but just consolidating, ie. moving sideways in a range. Bollinger bands are especially useful in ranging markets because (with correct settings) they highlight the areas where the market is oversold (at or near to a support level) or overbought (at or near to a resistance level).
When a market is trading sideways the bands can provide us with volatility adjusted support and resistance areas. In this approach price reversals in the proximity of the bands provide us with signals either to buy or sell. Sometimes the market bounces from the bands and sometimes the reversal takes place either just below or just above the bands. This however isn’t that important. Rather it’s the price action itself that provides us with the necessary evidence that the market participants are indeed paying attention to the levels indicated by the bands.
Therefore, the proximity of the bands provide us with a clue that the area could be a potential reversal area but the price action itself has to confirm the idea. Only then does it make sense to take a trade.
Bollinger bands are also a popular tool for programmers that created automated trading systems. They are adaptive and function often as dynamic supports or resistances which allows systematic traders to build other algorithms that monitor price action (such as reversal identifiers) around the bands.
This is why, especially during ranging markets, Bollinger bands can provide us with quality trade entries. When trading a reversal strategy in a range we look to take quick profits near to the opposite band. For example, if a trade is opened short at the upper band the strategy looks to take profits near to the lower band.
As the way Bollinger bands measure volatility isn’t timeframe dependent we can use them in all timeframes. Therefore, whether you are looking for a tool for active intraday trading or for swing trading using daily charts Bollinger Bands can be a valuable tool for you.
Buying at the lower band in an uptrend
Traders should also learn to find trends in both daily and intraday charts. They are easy to spot as they practically are just a series of higher lows and higher highs or vice versa. In an uptrend, this strategy looks to engage the market when it pulls back to or near the lower Bollinger Band and then looks to hold the trade until the trend reverses.
Both of these strategies can be used in all timeframes but those looking to trade using the small time frame charts, e.g. 5 min need to also pay attention to the spread and the recent range. If you are trading in a market that has a recent range of 10 to 15 pips and your broker offers you a 2 pip spread, making money can be extremely difficult.
We recommend changing the broker and trade with TIOmarkets that offers razor tight spreads. As an example, at the time of writing this GBPUSD trades with a 1.1 pip spread and EURUSD with a spread of 0.7 pips. Spreads, of course, vary to a certain extent (expand in a fast or illiquid market) but you really don’t want the expansion to start from say 2.5 pips. The spread is a cost andd quite a significant one: If you trade e.g. average 10 times a day over a year (250 trading days) every extra pip in the spread costs you 2500 pips in a year. We strongly encourage you to check how tight spreads TIOmarkets can offer to you!
Chief Market Analyst
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