Traders have many choices when it comes to indicators. Moving averages, stochastics, RSI and ADX are just a few. Bollinger Bands are another popular choice and combine a moving average with an upper band and a lower band.
The typical setting for Bollinger Bands is to use a 20-period simple moving average as the center line. The upper band is then drawn two standard deviations above the simple moving average while the lower band is drawn two standard deviations below the simple moving average.
Bollinger Bands may be useful for defining a relative high and low. Wider bands may demonstrate market volatility while tighter bands may indicate low volatility.
Bollinger Bands can be useful for entering into a market in the direction of the prevailing trend when the market becomes relatively overbought or oversold.
Below is a simple trading strategy using these bands designed to try to capture potentially large market moves in the direction of the trend while trying to keep risk to a minimum. Stock ABC will be used for example purposes.
- Place Bollinger Bands on a daily or weekly chart of stock ABC.
- If the simple moving average is pointing up, look for longs. If the moving average is pointing down, look for shorts.
- In this example, the moving average is pointing higher, so you will look for a potential long entry.
- A signal is triggered if the market sees some selling and touches the lower band on the daily or weekly chart.
- Look to enter a long position if ABC trades above the high of the bar or candlestick that touched the lower band.
- Place a stop-loss order below the low of the bar or candle that touched the lower band, or closer if there is considerable distance.
- Look for a move back to the moving average center line, or perhaps back to the upper band.
- Trail your stop or otherwise manage the position.
The idea of this strategy is to enter into the direction of the trend when the market becomes relatively overbought or oversold. Initial stops may be placed close to the point of entry allowing for potentially favorable risk/reward scenarios.
