- September 22, 2021
- Posted by: CoachShane
- Category: Trading Article
The Bollinger Band Breakout Strategy uses volatility and prior swing highs and lows for trading opportunities.
John Bollinger created these bands that uses a moving average and standard deviation from that moving average. It is commonly used as an oversold and overbought technical analysis indicator. We will be using oversold and overbought as signs of weakness and strength.
Bollinger Band Indicator Design
There are 3 components to the Bollinger Band:
- Moving Average: A simple moving average using a default setting of 20 periods is generally used but traders use various numbers
- Upper Band: The band sits, generally, 2 standard deviations above the moving average
- Lower Band: The band sits, generally, 2 standard deviations below the moving average
The premise behind the indicator is that 80-85% of all price action should be contained between the upper Bollinger band and the lower Bollinger band.
Any excursion to the bands is time to take notice of the instrument.
Notice bands do not stay in a close proximity to each other:
- During periods of low market volatility, you will see the bands come closer together
- When high volatility is present, you will notice the bands getting further apart.
We are going to use this feature of measuring higher volatility as part of the Bollinger Band trading strategy.
For traders looking to take advantage of low volatility market conditions, check out the Bollinger Band Squeeze.
Bollinger Band Strategy
There are 3 main trading strategies you can use with this technical indicator:
- Buy or sell breakouts of the bands
- Trade reversals back to the middle band
- Trade reversals from the middle band
We are going to focus on breakouts with the idea of catching the beginning of strong trends in price. Any market or time frame can be used for this simple trading strategy.
For the Bollinger Band settings, we will use the default settings:
- 20 period simple moving average for the middle line
- 2 standard deviations for the upper and lower band
Traders will be looking for an increase in volatility as well as a support level or resistance level being broken.
The strategy will use breaks of level that actually indicates the trend direction. To avoid trading in consolidated markets, traders may want to consider the slope of the outer bands.
This chart shows the slope of the bands in both a trending and consolidating instrument. Each trader is different and some may filter out trades in consolidated markets.
There is no one size fits all and volatility contractions may suit some traders. In fact, you may find it a great addition to this strategy.
You can also increase or decrease the time period the chart when markets are trading in a range. You can often find a trend on a different time frame.
Let’s consider a sell signal short trade on a time frame day traders may use, the 5 minute chart.
As part of the trading rules, we will be looking for price movements that not only break the lower band, but also a support level.
Breaking this chart down:
- Price breaks a level of support
- Price moves through the Bollinger Band to the downside
- Price breaks the low at 2 and through the bottom band
- Is a trade long
As this is a short time frame, traders would want to ensure that their stop loss is adjusted as price moves in your favor.
Where to set a stop loss
Managing risk is vital and one part of it is knowing what your exit point will be.
The simplest method is to use the high of the candlestick that triggers the trade.
As price moves in your favor, you can use a trailing stop to lock in profits.
Let’s look at a daily chart.
Pretty simple setup for swing traders:
- Prior support level gets broken after…..
- Price had broken the lower band of the Bollinger
There are different ways to enter and traders will have to decide if they will:
- Enter on the break
- Enter when price closes
- Set a sell stop order to short once price breaks the low of the trigger candlestick
Ensure that your trading plan has your exact entry and exit criteria.
What goes down, will probably go up eventually so let’s look at a few buy examples.
Buying won’t be much different than sells but let’s break it down.
This is a picture perfect daily chart setup. Price, at the same time, as broken resistance and the upper Bollinger Band.
Your stop would go right under the entry candle highlighted by the black arrow.
Long Term Trading
This strategy works well for day trading but what about longer term trading?
Price breaks the upper band and stalls around one of the resistance levels.
Once price breakout of the last resistance and pulls back. price takes off into a strong trend.
One of the easiest ways to take your profits with Bollinger Bands is, if in a long trade, take profits if price pulls back into the middle line.
The middle line can be used to trail your stop loss. In this case, the weekly chart pushed upwards and would have exit for a 19% price gain.
I like this 15 minute chart as it wraps up much of what we have discussed.
The trade signal entry is obvious as it broke a resistance level and the upper Bollinger Band.
For the up trend to continue, the resistance level has to break. This is a great spot to consider taking profits as it used market structure known as a double top. For shorts, it would be a double bottom.
The new entry works well and eventually gets stopped out with the trailing stop on the moving average.
The rules of the strategy that will suit you still have to be decided upon.
This discussion has given you an entry setup as well as the bones of stop loss management.
Whether you ride the trend or take profits at certain points will depend on your trading style.
In a perfect world, we get a strong uptrend or downtrend after these breakouts. It won’t always work like that so risk management is something you must spend time on.