Bollinger Bands Trading Strategy: Everything You Need to Know About the Bollinger Bands Indicator

Have you heard about Bollinger bands, but not quite sure what they are, how to use them, and how they could actually impact your trading so that you can make a lot more money?

My name is Adrian Reed and I'm founder of Enlightened Stock Trading. And in this video, I'm going to explain everything about Bollinger bands that you need to know so you can start using them and make money and start trading more profitably. So what is a Bollinger band? Well, the Bollinger band was invented by a guy named John Bollinger in, I think, like the 1960s, ages ago. Anyway, they've been around for a very long time, and it's a really powerful technical indicator that it can be used in a number of different ways. So on my chart here, I've got a Bollinger band plotted. And I just did this so that I could sort of explain to you how it works. This chart's plotted in amibroker, and I've got the daily stock chart of a stock called Afterpay and in Australia, and I've got the Bollinger bands plotted on here. Now, the Bollinger band consists of three things. The first one, which you probably know and love, is a simple moving average. A simple moving average is the center line of the Bollinger band. And this simple moving average can be any length that you want, depending on what you're trying to achieve with the Bollinger band. The second component of the Bollinger band is the top Bollinger band, which is the simple moving average plus some multiple of the standard deviation. So typically, the most. The most commonly used settings for the Bollinger bands are two standard deviation Bollinger bands. So what that means is you've got the simple moving average, and then the top Bollinger band is at the simple moving average + 2 times the standard deviation. And then the third component is the bottom Bollinger band. So that's the simple Moving Average -2 times the standard deviation. Now, you can use several different settings for the Bollinger bands. I'll go into the settings and what you're going to use them for later on in this video and blog post. So the formula is pretty straightforward. For the top band, it's the simple moving average + x times the standard deviation for the bottom. And so I'll give you this one. And then for the bottom Bollinger band, it's the simple moving average minus x times the standard deviation. And you can vary two inputs in the Bollinger bands, the length or duration of the Bollinger band, which could be anywhere from a couple of days to 200 days. And you can vary the number of standard deviations in the Bollinger band. The higher the standard deviation number, the wider the bands, the lower the standard deviation number, the tighter the bands are more closely wrapped around the simple moving average. So how do you use Bollinger bands for your trading? Bollinger band trading can happen in a couple of different ways. So let's talk first about trend trading with Bollinger bands. So trend trading with Bollinger bands, what you're looking for are breakouts with the Bollinger bands. So if I zoom out on this chart, you'll see that afterpay, this stock has been trending really strongly since about March, April 2020. Okay. And what do you notice during this whole uptrend is the price is very close to the top Bollinger band. It basically hugs the top Bollinger band. So, so this is a 20 day Bollinger band with a 2 standard deviation.

Multiple on the Bollinger band. And so when the uptrend starts, you'll see down here, it hits the top Bollinger band actually in fact closes above the top Bollinger band. And then for the duration of the trend, it stays near the upper Bollinger band, and it stayed near the upper Bollinger band almost this whole time. And if we go further back, you'll see there's other periods where it was trending up and then it started trending down and actually touched or broke below the lower Bollinger band. So for trend following or trend trading with Bollinger bands, what you're looking for is a new uptrend, which is signaled by a breakout, the price closing above the upper Bollinger band. Like down here, there's a breakout above the upper Bollinger band. Or here these signal that the price is strong and moving up. Okay, now with trend trading, you're getting in on a breakout or a new trend, hoping that or expecting that the trend will continue. And a breakout above the upper Bollinger band is a good indication of that happening. And if you can use Bollinger bands for your entry, you can also use them for the exit. So here you've got a breakout above the upper Bollinger band for your entry. You could use a breakout below the lower Bollinger band for your exit, or you could just exit below a simple moving average or an exponential moving average or a trailing stop or something like that. So a Bollinger Band breakout entry combined with a typical trend following exit, like a trailing percentage trailing stop or an ATR based trailing stop or close below a long term moving average, like a 200 day moving average or even a breakout below the bottom Bollinger band can make a really solid trend trading strategy. Okay, so that's how you use Bollinger bands in trend trading. Now in mean reversion you can also use Bollinger bands. So how do you use Bollinger bands for mean reversion trading systems? Well, what you're doing here with mean reversion is you're trying to fade the short term move. If the price has spiked down, you're going to buy it expecting for it to bounce up back reverting back to the mean. Or if price has really spiked up, you're going to short it expecting it to bounce down so you can cover at a profit. Again, reversion to the mean. So to use Bollinger bands for mean reversion, what you're looking for, let's just find a more flat period in this stock. Okay, in here.

For mean reversion, what you're looking to do is fade the breakout or fade the price move above the top Bollinger band. So let's say here the price is there's no real trend in the stock, but short term the price has jumped up and it's just crossed above the top Bollinger band. That'd be a good mean reversion trade to get short and in anticipation of covering down here, either below the moving average or towards the bottom Bollinger band. Then similarly here you might look to go long when the price closes or crosses below the bottom Bollinger band in anticipation of this rally and exit, exit long when the price crosses above the moving average or when it approaches the upper Bollinger band. Now mean reversion with Bollinger bands you've got to make sure that it's not a new trend. So you don't want to buy a breakout when the moving average is going up. Right? So over here on the right hand side, this is actually the start of a new uptrend. And it's a bit hard to tell at the time, but if you zoom right out, let me just zoom out, you can see here we've got the breakout above the top Bollinger band. That's the start of a new uptrend. And you can sort of tell to some extent because the moving average is already sloping up, prices really starting to increase. Whereas here where.

This breakout in here is in the middle of a downtrend. That's a much better short trade. You would want to short this one because the stock price is already moving up, the moving average is moving up. It's much more likely to be a long term trend. Now, I want to stress with these ideas, you don't want to just trade these on blind faith, okay? You want to take these signals, you want to put them into your backtesting software like amibroker, and you want to back test them as a complete trading system and see if they've actually got an edge in the market. So these are good ideas, but you need to test them in your markets and see if they actually can generate the level of profit that you want. Don't just trade any indicator on blind faith, okay? You must back test it and see if it actually works. So that's back. That's trading Bollinger bands with trend trading and with mean reversion. Now there's another one, another approach called Bollinger band squeeze, which is where there's a good example of this right down in here, if I just scroll back.

Bollinger bands expand when volatility expands and contract when the volatility shrinks. And when the Bollinger bands squeeze right together in around the moving average like this, it can be a good entry to buy in anticipation of a breakout. So you're buying a Bollinger band squeeze in anticipation of a breakout. And so you want to, you want to trade in the direction of the primary trend. So you can see here, the primary trend is up, right? So if there's a Bollinger band squeeze in an uptrend, you're not going short because the probabilities lie in a breakout to the upside. What you're doing is you're using the primary trend and the squeezing together of the Bollinger bands to position yourself in anticipation of getting a breakout like this. Okay? If you do that, you're getting a very low risk entry because if you enter in here, volatility is low. You can place your stop loss pretty tight underneath your entry point. And if price starts to turn down, then you get out really quick without a large loss. But if you do get this breakout that often comes after a Bollinger band squeeze, then you can ride this upswing.

For a while and exit a profit later on, either with a profit target or a close below a short term moving average or something like that. So Bollinger bands squeeze is another good way to use Bollinger bands in a trading system. Now, again, Please do not use any technical indicator without backtesting it first. You want to use software like amibroker to put your rules, your entries, your exits, your position, sizing in into your software, back test it over 20, 30 years of data over thousands of stocks and make sure the strategy actually has a real edge. This is a really well chosen example and it perfectly well illustrates this Bollinger band squeeze. But there's going to be many times where the Bollinger band does squeeze down, but there isn't a great breakout as a result of that squeeze. So not every trade is going to be as beautiful as this one. You need to back test and make sure that on average over many hundreds of trades, you're going to make money. So there's three methods for you to use Bollinger bands in your stock trading systems. Now, what about the Bollinger bands settings? We've talked about two different types of settings in the Bollinger bands and in amibroker we can just edit these settings here. I'll just right click and go to parameters. If I scroll down to the Bollinger bands here, you can see we've got the periods, which is the number of days, and we've got the width, which is the standard deviation multiple. Okay, so at the moment we've got a 20 bar, 20 day Bollinger band with a 2 standard deviation. Let's first play with the standard deviations. Okay, so the most common settings are one or two or three standard deviations, but there's no need for it to be a whole number. You could use one and a half to one and a quarter, three and a half, whatever it is. And the idea with any technical indicator setting or parameter value is backtest it and see which one is best. You can optimize your parameter values very, very easily using a software like amibroker and see which breakout which which.

The simple moving average. So the the idea of the Bollinger width is if you want to have a more strict entry, then you use a larger standard deviation multiple, two, three or four standard deviations. If you want to have a very easy entry that gets you in or out quickly and easily, then without much price movement, then you want to use a narrower standard deviation multiple. So one standard deviation would be quite an easy entry. You'll see this many times on this chart where the price breaks above the one standard deviation multiple and also many times where the price breaks below the one standard deviation lower Bollinger band. If you want to have a more difficult or more strict entry, let's change it. Instead of one, let's change it to three. See what happens. You can see, let's get rid of this. You can see that the Bollinger bands are much wider. Okay? It's three times the standard deviation over the last 20 days. And so for the price to get above the upper Bollinger band or below the lower Bollinger band, it has to move much more forcefully, much more quickly, and you'll see it happens here. This is a really strong breakout down here on this chart. This price on this bar closes above the lower. The upper Bollinger band. This closes above the 3 standard deviation 20 bar Bollinger band. So that's a very strong breakout. So that could be a good trend following entry. Because in trend following, you want to buy strength, okay? In mean reversion, you're going to short strength. But this is clearly a new trend. It's a very strong move. And so that would be a good trend entry. So that is the standard deviation multiple or width of the Bollinger band. Let's now have a look at what happens with the number of periods. Okay, so change this back to two standard deviations and we've got a 20 bar Bollinger band. Now if I change that from 20 bars, let's change it to 200 bars. Just to take an extreme view. Now, what happens when you expand the number of periods in the Bollinger band is it uses more bars of data to calculate both the moving average and the standard deviation. So what we're going to see is a broader standard deviation and quite a different shape of Bollinger band. So I've got to. Oops, hang on. What happened here? Come back. It's not gonna let me do a 200 bar Bollinger band. Let's do 100 bars Bollinger band. Okay, cool. Oh, there we go. Okay, so you can see 100 bar Bollinger band. Oh, and I also need to change my moving average. Where's the moving average? Here it is. So I'll Change this to 100 bars so it matches.

100 bars. So it matches not 500 bars. There we go. Okay, so now we've got 100 bars standard deviation Bollinger band and 100 bars moving average. And you can see that these are much slower moving Bollinger bands now. Okay, so it takes a much bigger move in the stock price to get above the upper Bollinger band or below the lower Bollinger band. But again, you can use it the same way. So you could buy. Use These breaks above the upper Bollinger band as a trend following entry. This one here would be a really great trend following entry and start of a very strong uptrend. And then you just need to combine that with an exit, as we talked about earlier in this video.

But you see, the longer the number of periods in the Bollinger band calculation, the smoother the bands are and the slower it is to react. So you can tune both the width and the duration of the Bollinger bands to meet your needs. If you want a longer term system, use a larger number of periods. If you want a system that trades less often, use a wider Bollinger band and you're going to get higher average profit per trade, but much fewer trades. If you want a system that trades much more often because you need more activity, then have a narrower Bollinger band and you get more signals. But those signals won't necessarily be as good. So that's all about Bollinger bands settings. There's a couple of creative ways that you can use Bollinger bands as well. There's a thing called a percent B oscillator. Now, I don't have this plotted on the chart here, but percent B is it converts Bollinger bands into an oscillator. And the way it works is it takes the upper Bollinger band and assigns it a value of 100 and the lower Bollinger band and assigns it a value of zero. And every day the price is somewhere usually between those upper and lower Bollinger bands. So if the price is right in the middle, the percent B will be 50, 50% because it's halfway. If the volume, if the price rather is right at the bottom Bollinger band, then the percent B will be zero. If the price is right at the top Bollinger band, the percent B will be 100. If it's just above the top Bollinger band, then the percent B will be above 100. So it can oscillate above 100 as well and it can go below zero. But.

The reason you might do that is when you're thinking about mean reversion, often, often an oscillator style.

Indicator is much more, much more natural to think about and use. So rather than plotting the Bollinger bands on the chart, you plot the percent B as a indicator in a pain below the chart and you can see the oversold and the overbought points in that chart. So changing the Bollinger bands to an oscillator by using percent B is one Interesting creative approach. Another interesting or useful way you can use Bollinger bands is as a trend filter. So let me just change this one here. Let's change this back to a 20 bar moving 20 bar Bollinger band, and we'll give ourselves a 20 day moving average as well.

And so to use Bollinger bands as a trend filter, you might say, actually, let's make this a one period, a one standard deviation multiple. So you might say, as a trend filter, this stock is trending strongly whenever price is above the upper Bollinger band. So you can see there's a strong trend here, there's a bit of a trend here, there's a strong, strong trend here, and it continues there. And then there's another strong trend out to the side. So you can use the upper Bollinger band as a threshold, if you like, to indicate when the trend is really strong versus weak or down. And this is useful as part of a holistic trend trading system. So you might say, okay, my setup or my trend indicator is price above the upper Bollinger band. But then you have a certain chart pattern or candlestick pattern that you might use as your precise entry trigger, telling you exactly what day to get in, provided the trend filter is true. So you can use Bollinger band as a trend filter, not just an entry trigger. You can also use Bollinger bands as your stop loss level. So on the day you get in, let's say we enter on this, this day here, you might use the lower Bollinger band on that day as your stop loss level. Now, setting your stop loss level like this is really powerful because your stop loss is linked to to the volatility of the stock. So a very wildly volatile stock will have a wide stop loss because the standard deviation is high. A very quiet, calm stock will have a tighter stop loss because the standard deviation is lower. So using Bollinger bands is similar to using average true range for your stop loss because it's linked to the volatility of the stock. And if that stock gets more volatile over time and you took a trade later on when it's more volatile, the stop loss is going to be wider. The key to a good stop loss is it's adaptable, adjustable to the volatility of the instrument you're trading at the time. So, creative ways to use Bollinger band, there are three really great creative ways. The percent b for mean reversion systems, as a trend filter, which is part of your trend trading system, or as the stop loss level as an alternative to say, an average true range initial stop loss.

So in this video, in this blog, we've covered a couple of things. We covered what are Bollinger bands, the formula to calculate Bollinger bands. We've covered Bollinger band trading, which you can do with trend trading systems, mean reversion systems, and you can also use Bollinger band squeezes to trade in anticipation of breakouts. We've talked about the settings which include the length and the multiple or width of the Bollinger bands and how you can use those to fine tune the Bollinger bands to do what you need and also three creative ways to use Bollinger bands in your trading. So the key above all else is to take these ideas and backtest them for yourself in your stock trading systems. So you want to use software like Amibroker to put your ideas in, backtest them over 10 or 20 years of history, over thousands of stocks, because that's what's going to give you the confidence that that this rule has an edge in your market. Please don't fall victim to the typical trap of seeing a couple of well chosen examples on a video like this one and just trading it because it's not going to give you enough confidence and it may not be as profitable as you think. Systematic trading and backtesting your ideas is the way to build that confidence. So if you want to learn how to trade systematically, how to launch your systematic trading career in just six weeks or less, click the link below and join System Trader Launchpad, which is Enlightened Stock Trading's entry level program to introduce you to systematic trading, show you how to backtest, show you how to follow and use a profitable trading system and get started in just six weeks or less. Doesn't matter whether you're a new trader or you're an experienced technical analyst, this is the way to start trading systematically to be build confidence in your trading by backtesting your ideas and making sure they're profitable before risking a single dollar in the market. So click the link below, find out about System Trader Launchpad and I hope to see you inside the program. Bye for now.