The concept of buying low and selling high invariably incorporates comparison, but what should we compare prices to? The answer to this question is provided by Bollinger bands. The statistical analysis furnished by these tools can be extremely useful if used appropriately. One special approach for making use of Bollinger bands as buy signals actually utilizes the bands in an unusual way, but does so rather successfully. This post will describe how to use the outside of the Bollinger bands to determine great buying opportunities.
The bands in Bollinger bands are used to symbolize volatility measures that are positioned over and below a moving average. The volatility measure is based on the standard deviation. As the standard deviation changes with the change in volatility, the Bollinger bands broaden with rise in volatility and narrow with decrease in volatility. Due to the dynamic structure of Bollinger bands, it is possible to use them on different securities with the standard settings. In order to use the technique described in this post, the default settings of Bollinger bands must be modified.
A lot of charting packages can make the customizations to Bollinger bands described here, but if you don’t have one that can do this, or if you don’t know where to begin, consider freestockcharts.com. For the charting examples in this article, we have used the same site.
This modification incorporates four steps:
- As a proxy for the trend, a moving average price, preferably a 44-period simple moving average price must be used. However, you do have the liberty of making use of just about any moving average between 40-periods and 100-periods. Making use of a 44-period average is not absolutely obligatory. You can get an idea of trading from the slope of this line, when it is sloping up, long and when it is sloping down, short.
- Instead of the default 20-day average for normal trading, you should utilize a 5-day average. This setting is for short term trading, which means we will trade from one week to three months.
- Alter the standard deviation from 2 to 1.4 to select a region which covers 90% of normal prices. When making use of freestockcharts.com edit the Bollinger band indicator that you have applied. You must adjust two things; the standard period from 20 to 5 and the standard deviation from 2 to 1.4.
- You should seek buy signals when the moving average is sloping upward and the price is under the Bollinger band.
Let’s take a look at two examples:
The figure below shows the chart DIS (Disney) for the first 3 months of the year. In the first month, the price dropped down the Bollinger bands on ten different days.
Once the price falls under the Bollinger band, the stock turns up and the price keeps rising. So, when the price falls below the bands, it is an entry signal. You can duplicate these indicators using freestockcharts.com or another charting package that lets you change the Bollinger band indicator that you have applied. You have to adjust two things; the standard period from 20 to 5 and the standard deviation from 2 to 1.4.
This is a very easy entry signal to determine and use. As you can tell, throughout the next couple of months there are many times when the price falls under the Bollinger band, and every time the stock goes higher at some point in the subsequent 5 trading days. Keep in mind, that the moving average line should be sloping up in order for this entry signal to offer highest success.
Again referring to the chart, you would have been able to make a profitable trade, if you had purchased on any of the ten days when Disney fell below the Bollinger bands. Disney increased from these entry prices by around 12% in the next two months, and each trading signal had at least one day in the subsequent week where the price increased more than it fell.
With testing it has also been revealed that you can win this trade over 70% of the time if you do two things: allow a three to five percent stop loss setting and take profit whenever the price increases more than two percent from the entry point. In addition, about 10 to 20 percent of the trades you come across will be instances where you can let the trade run in your favor beyond the original two percent target. These rules turn the Bollinger bands from a curious indicator to an extremely lucrative trading approach.
The chart below is for XHB (Homebuilders), which shows prices for February to May. In the month of February, there are 9 instances when the prices drop below the lower band, which is an entry signal.
XHB rose more than 10% in the following month for someone who bought this stock at any one of the 9 entry signals in February. If you are working with this technique, then it is essential to adhere to all the instructions to letter without ignoring any single detail. As you can tell that on May 15 in the above chart, the 44-period moving average is sloping downward. You have to take care of all such details.
Nonetheless, if you follow the first step mentioned above, then there would be no chance of entering the trade after May 15. In this way you do not lose money by trading in a downward trend market. As soon as the moving average peaks and starts to turn over, exit your trades and don’t get back into any, with this method, until the moving average line is again sloping up.
Bollinger bands is a sophisticated tool and people use it in several different ways. If you want obvious entry signals that you can follow readily, then you should use this method. Once more, you must ensure that you follow the four steps to the letter so that you don’t lose money. A 44-period simple moving average is ideally suited to be used in this method. However, any moving average between 40-periods and 100-period moving averages will work almost as well as a proxy for the trend. You might not have heard about this unconventional method of using Bollinger bands before, but this is a straightforward method that gives clear entry signals where you can purchase and earn unusual profits.
A great way to make profitable trades is with the assistance of Bollinger band trading. Regardless of whether you trade forex, stocks, or even options, if you know what the bands are saying then you can readily make lucrative trades. If you are a trader, then you need to learn how to trade Bollinger bands to earn more profit.