Published on February 12, 2014
THE CMC Markets Trading Smart Series Harnessing Volatility with Bollinger Bands
As a trader, you need to have a good understanding of the nature of market volatility and the way it impacts your positions. One of the most popular – and one of the most reliable – tools that traders have at their disposal is Bollinger Bands, developed in the 1980s and named after its creator, John Bollinger. Proudly No. 1 for CFD education Results from Investment Trends September 2010 Singapore CFD Report, based on ratings given by 8,900 investors CMC Markets | Harnessing Volatility with Bollinger Bands 2
Harnessing Volatility with Bollinger Bands Understand one of the key tools for any trader. Find out how to put one of the methods described by John Bollinger into practice. Gain an understanding of the limitations of Bolliner Bands, and what it really represents. What are Bollinger Bands? When it comes to watching price movements of any instrument that you’re trading, it is very useful to have an understanding of where price is trading relative to its average. The moving average is a popular way of doing this, because it demonstrates the average value of the instrument over recent trading conditions. When you see the price above the moving average you may think it’s bullish, and when it is below you may think it’s bearish. What do you feel, however, if the price is a long way above or below the moving average? And is it too far above or below the moving average for you to still feel bullish or bearish? Maybe now you want to be a contrarian! Bollinger Bands add a further assessment of recent trading activity by using a very powerful statistical measurement tool: the standard deviation. In essence, the standard deviation provides a value within which the price has a probability of not moving further. A simpler way to say this is that if the price moves outside the envelope formed by the standard deviations, then it is quite a significant event. We will look at this in more depth, but for now the key thing is recognising that the envelope formed by the Bollinger Bands can be quite useful in gaining an appreciation of how far price has moved away from its average – and what you can do about it. Before going any further, however, we need to look a little more at standard deviation to help you gain an appreciation of what that means to you as a follower of Bollinger Bands. 68 95 99 -4.0 -2.0 0.0 2.0 4.0 CHART 1 Two standard deviations covers 95% of expected distribution. In chart 1, you can see a distribution, or bell, curve. This tells you that based on the number of observations that have been taken (for example, index prices over the last 20 days), 95% will occur within +/–2 standard deviations of the moving average. CMC Markets | Harnessing Volatility with Bollinger Bands 3
What does this distribution curve mean to you? It is of real importance, because the Bollinger Bands are placed at a distance of +2 and –2 standard deviations away from the moving average. So if you don’t have any idea what the relevance of the standard deviation is, you are not going to know what the Bollinger Bands are telling you. The main thing to think about at this point is that the envelope of the bands should contain the vast majority of trading activity. Therefore, a move outside of these bands is, in fact, a statistically very significant event. In this guide we want to consider what you need to do when this occurs. because the bands are based on standard deviations, they will widen and narrow around the moving average depending on the recent level of volatility that the price has demonstrated. This means that the lower the level of recent price volatility, the narrower the bands will be. The greater the recent volatility has been, the greater the width of the range contained by the bands. Merely by looking at the bands it is possible to get a very good idea of what the recent trading conditions have been like for the instrument that you are considering. There are a large number of different ways in which traders interpret this information. We examine one that was espoused by John Bollinger himself. How Bollinger Bands apply to your trading You may also think that putting a fixed percentage amount as an envelope above and below the price may be an effective way of containing the majority of price movement. This may be the case, but it lacks a crucial advantage of the Bollinger Bands: the fact that Now that we’ve looked at the composite parts of the standard deviation, it’s time to take a look at the Bollinger Bands themselves and how they apply to your trading. A typical chart with the Bollinger Bands in place might look something like chart 2: CHART 2 Bollinger Bands adapt to changing market conditions. The Bollinger Bands are represented by the three lines around the price movements. The middle line is the 20-period moving average. This is the default value of this component of the indicator. The upper line is the value of the moving average plus two standard deviations, while the lower line is the moving average minus two standard deviations. You can see how these upper and lower bands envelope the price for the majority of the time. For traders who use Bollinger Bands, the time of greatest interest is when the price moves outside of the bands, because this is what would be referred to as a statistically significant event. It is important to be able to respond accordingly to the setups you are provided with. CMC Markets | Harnessing Volatility with Bollinger Bands 4
and back. Similar to strategies for rectangle patterns, however, the trading between bands is difficult. First, by definition, except for fixed envelopes the bands contract during a sideways, dull trend and leave little room for manoeuvring at a cost-effective manner and with profitable results. Second, when prices suddenly move on a new trend, they will tend to remain close to the band in the direction of the trend and give many false exit signals. Third, when the bands expand, they show that volatility has increased, usually due to the beginning of a new trend, and any position entered in anticipation of low volatility is quickly stopped out. What you can take away from this is that you shouldn’t try to use Bollinger Bands in the same way as you might use some other type of indicators that tell you an instrument may be overbought or oversold. Instead, these bands show you when a new trend may be developing, so you should generally resist the temptation of trading against the direction of the initial breakout of the price through either the upper or the lower bands. Some traders will look to this breakout-type trade as a means of going long or short if the price closes above the upper band, or short if it closes below the lower band. The trade remains in place until the price closes on the far side of the moving average line that runs between the two standard deviation lines. CHART 3 Price movements outside the bands are statistically significant. Chart 3 is simply a closer look at one of the components contained in chart 2. You can see that when price starts to move very quickly it moves outside the boundaries of the bands. What also adjusts quickly is the direction and the width of the bands. The main trading method that we want to discuss using Bollinger Bands is one described by John Bollinger himself in his 2002 book, Bollinger on Bollinger Bands. What you are looking for in this setup is called a W formation. Bollinger describes several different variations of the W formation in his book, but we will be looking at it in general terms. The name of this setup provides a good idea as to the shape of the price pattern that you are looking for: a W. The thing that you need to put more thought into, however, is how this pattern then interacts with Bollinger Bands. In general terms, when the instrument becomes more volatile the bands move further apart. This is because the standard deviation value increases. When the price moves in one direction consistently, the moving average will gradually change direction to follow it. It is for these reasons that the price generally will not stay outside of the Bollinger Bands for very long: they adapt to keep price trading within them. The W formation In this guide we are primarily examining a single methodology to apply using the Bollinger Bands. However, to better illustrate its use it is important to describe at least the groundings of another method which can be employed at the breakout of the Bollinger Bands. One of the books on the general topic, Technical Analysis by Kirkpatrick and Dahlquist, leads the authors’ discussion with the following: line with the basic concept of following the trend, bands and envelopes are In used to signal when a trend change has occurred and to reduce the number of whipsaws that occur within a tight trading range. While looking at the envelopes or bands on a chart, one would think that the best use of them might be to trade within them from the high extreme to the low extreme CMC Markets | Harnessing Volatility with Bollinger Bands 5
CHART 4 The beginnings of a trade setup. As with many setups, the W is one that can be used for trading on either the long side or the short side. All the examples below can be reversed and traded in the opposite direction where the initial setup is the opposite, depending on whether you start with an uptrend or a downtrend. For our first example, we will start without the Bollinger Bands so you can see the basic setup pattern to look for, in this case a strong trending movement either upwards or downwards. In chart 4, you are looking at a downtrend. The circled component of chart 4 highlights the W. This is where the trend has bottomed and then retested after a short reversal, which forms the pattern we’re interested in. The right hand low can be higher than, equal to, or lower than the previous low. In the next chart we take a look at the same setup, but add in the Bollinger Bands because this enables us to measure how extreme a movement we are viewing. CHART 5 Overlay the pattern onto the Bollinger Bands. The point where the arrow is drawing your attention in chart 5 is the first low. The key takeout from this is that the low point of this first trend trough in the W formation is outside the Bollinger Bands (it is also acceptable for the price to just touch the band). As discussed earlier, this is quite a significant event considering how much of the price action you would expect the two-standard-deviation envelope to contain. You can see that the second trough is inside the bands. The Bollinger Bands are telling us that while the first trough has a statistically high variance from the moving average, the second trough – being inside the bands – does not. To a trader looking only at price, the market still looks weak. However, a trader using Bollinger Bands is being given a clue that the trend is losing momentum. Changes in momentum often precede changes in trend and, used judiciously, can be a useful tool for traders looking to get set early in the life of a trend. CMC Markets | Harnessing Volatility with Bollinger Bands 6
Buy Second trough in the W. Note that the candle low is inside the lower Bollinger Band and surrounded by two higher lows. CHART 6 The formation of the second trough is the key signal. Once the pattern forms the second trough, as in chart 6, you will look to make an entry into the trade. The way to know that a trough has been formed is when the instrument being traded closes above the highest point of the candle that made the lowest low (that is, the lowest point of the trough). You should wait until it has closed at this level so that you have confirmation of this W formation. CHART 7 The same pattern reversed can give a good short trade. Chart 7 presents an example of a trade that would trigger as a short position. In this case you are looking for an M formation. It pays not to be too precise in looking for a perfect M. The two peaks can be quite lopsided, with the second one quite a bit higher or lower than the first. The key thing is that the price on the first peak has moved outside of the Bollinger Bands and the second has remained within them. This demonstrates weakening deviation from the mean, even where the second peak is quite a bit higher than the first. This is a very useful trade setup for a wide range of different markets and timeframes. CMC Markets | Harnessing Volatility with Bollinger Bands 7
Bollinger Bands and stop loss As with any trade you make, you should have a very clear picture of where you place your stop loss. As something of a side note, you will likely find all of your trading becomes much more relaxing when you take on a sensible stop loss strategy, because you have then quantified your risk. Trading can be stressful for traders who have no plan as to when they will exit a losing trade. Sensible traders will know up front where they will place their stop and how much they will have at risk before they even enter the trade rather than trying to make their strategy up on the fly. 1st stop 2nd stop 3rd stop 4th stop Final stop CHART 8 Place your stop at the first point you know a reversal has occurred. In the case of chart 8 your first stop could be placed above the high point of the second peak in the M. The rationale for this should be quite easy to see: if the price reaches this level the pattern is no longer valid, so you have no reason to remain in the trade. Some traders will allow some tolerance above the peak to reduce the risk of being stopped out on a false break of the resistance. You will want to trail the stop lower as the trade continues to move in your favour so as to take the opportunity to lock any potential profits. You can see on the chart that one way of doing this would be to place the stop above each new corrective peak in the downtrend as it is subsequently formed. Review • ou should understand what standard deviation means Y and how to apply it as part of the Bollinger Bands. • ou should be able to search for trade setups and be able Y to determine which are suitable and which are not. • ou should be able to effectively manage your risk through Y applying a sensible stop loss strategy. CMC Markets | Harnessing Volatility with Bollinger Bands 8
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