Bollinger Band Strategy

8/9/2019 Bollinger Band Strategy

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Bollinger Bands

Pattern recognition is the process of recognizing recurring events. Patterns rarely repeat, if ever, in the

exact same manner. In general they look the same, and that is the problem. In order to be successful

with pattern recognition, some framework is needed wherein it can be analyzed. Bollinger bands are

one indicator that provides a very good frame work. Bollinger bands can help to identify rules which can

be used to interpret the formations. Definitions like new highs or new lows, sideways or volatile,

trending or trading. As the patterns evolve, the bands evolve right along with them, providing a relative

and flexible framework, rather than absolute, rigid frameworks imposed by the grid of a chart or trend

lines.

Markets seldom reverse in an abrupt manner. Usually reversals involve a sequence of price action which

includes one or more tests of support or resistance. Trend reversal patterns show the end of a

preceding trend and the start of a new trend. The new trend can be a reversal of a prior trend or a

transition from a trendless state. It can also be the beginning of a sideways trend or consolidation.

Most common reversal patterns are double tops or bottoms, head-and-shoulder patterns or three

pushes to a high. Some reversals can be brutal, and some dont turn out to be reversal patterns at all,

they just mark the end of the prior trend and a transition to a sideways market.

Bottom Reversals

A double bottom involves an initial decline followed by a recovery rally, and then a secondary decline

followed in turn by the initiation of an uptrend (Figure 1). When using Bollinger bands it is not

important whether the second decline makes a new low or not in absolute terms. As long as the first

low fall outside the lower Bollinger band, and the second low fall inside the lower band. The ideal

double bottom is a momentum low that occurs outside the lower Bollinger band, followed by a pricelow inside the lower band. Even if the price low has made a new absolute low, it is on a relative basis

not a new low. The rally that follows can then be acted on without the emotions usually involved with a

new low in the market. Where the second low is higher than the first low, frustration is the main

emotion, traders waiting on the support for the re test are left behind while the stock rallies. When we

have a proper re-test traders are satisfied and rewarded quickly. When the second low is lower than the

first low, fear and discomfort comes to a trader. Once shaken out they seldom have the courage to get

back in.

When looking at a decline you will get an accelerated move into the first low with the highest

momentum and with the biggest volumes. After this the market should recover inside the bands andsometimes even touching or tagging the mean (the middle line), followed by another decline

establishing the price low, which may be a new price low, but not necessarily, and will occur with less

momentum and less volume. Ideally volumes should be higher on the first decline than on the second.

Bottom reversals are generally cleaner and faster than top reversals. Bottoms are created in an

environment of fear and pain while tops are created in greed and euphoria. Bottoms are expected to be

sharper and more aggressive using less time, while tops should be more prolonged and less aggressive.

Down is faster - fear is a greater emotion than greed. The market falls on its own weight.


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High Momentum

Decline

Recovery

Rally

Secondary

Decline

Initiation Of

New Trend

Irrelevant If Absolute

Low or Not

Figure 1

A similar top is not necessarily a perfect mirror of the bottom pattern. The top will most likely take more

time, and may consist of three upward thrusts, rather than just the two. Top reversals may play out as

triple top or a variation on head-and-shoulder pattern.

Once you have a trade that fits the double bottom, wait for the first strong bullish candle or ideally wait

for a candle reversal formation then enter into the trade in anticipation of a wave 1. The stop loss

should be placed at the most recent low that is the second low of the double bottom.

Lows outside the lower Bollinger band followed by lows inside the lower band are typical bottom

reversal patterns, even when there is a new price low. Highs outside the upper Bollinger band followed

by highs inside the Bollinger band are typical top reversal patterns, even when there is a new price high.

The top reversal may consist of three upward pushes instead of two.

Pattern recognition is the key to successful technical analysis.

Top Reversals

Top reversals are quite different from bottom reversals. Tops are more complex and mainly consist of

triple tops or three pushes to a high. Most common of all is the head-and-shoulders. There are spike

tops that reverse up trends just as panic bottoms reverse the down trend, but they are rare.


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The classic head-and-shoulder pattern would be a left shoulder outside the upper Bollinger band

followed by a head that tagged the upper band, and the right shoulder that fail short of the upper band.

A very common variation of the head-and-shoulder is the three pushes to a high. The first push will be

outside the upper band followed by the second push making a new high, but only tag the upper band

without closing outside the upper band and then the third push making a marginal new high, or not but

will fail to tag the upper band.

To understand the Bollinger setup the rhythm of the market must be understood. The momentum of

the market is as always very important and the momentum need to be measured every time the market

approaches or breaking support or resistance levels. To be able to spot the early potential reversal

signal, what happens every time the price reaches the Bollinger band need to be studied. To identify the

occurrences as the market reaches the bands, three different terms will be used namely; close, tag and

failure. Figure 3 will demonstrate the three occurrences clearly before defining the different strategy

setups.

High Momentum

Rally

Secondary

Rally

Initiation Of

New Trend

Irrelevant If

Absolute High or Not

Retracement

Could also be 3 pushes

to the high

Figure 2


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Figure 3 show the different occurrences on Bollinger bands.

Bollinger close: When the price close below the lower band or closing above the upper band.

Bollinger tag: When the price spike through the band but still closes on the inside of the band.

Bollinger failure: Price action failed to tag or close outside the bands.

Bollinger Close

Bollinger Tag Bollinger Failure

Figure 3


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Bollinger Setups

By looking at the different events on the Bollinger Band mainly 3 types of setups can be recognised that

can predict potential trend reversals or potential wave ones.

The first setup involves a close followed by a tag while normal divergence is present. After spotting the

setup one has to wait for some form of confirmation before entering into a trade. Candle patterns

proved to be a very good entry confirmation. Once a candle pattern confirms the setup the trade may

be entered into. Mainly the target of a trade like this will be the opposite band. The opposite band will

change after each session as the Bollinger bands expand right along with the price action of the

instrument.

Candle Reversal

Enter into trade

Indicator

CloseTag

Target

Divergence

Bollinger Trade Setup 1


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The second setup involves a close followed by a failure while normal divergence is present. After

spotting the setup one has to wait for some form of confirmation before entering into a trade. Once a

candle pattern confirms the setup, the trade may be entered into. It is important that the price action

during a failure either touched the band or missed the band with a small margin. Failures not close to

the band will be worthless and may give false signals. Mainly the target of a trade like this will be the

opposite band. The opposite band will change after each session as the Bollinger bands expand right

along with the price action of the instrument.

Candle Reversal

Enter into trade

Indicator

Close

Failure

Target

Divergence



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The third setup involves a tag followed by a failure while normal divergence is present. After spotting

the setup one has to wait for some form of confirmation before entering into a trade. Once a candle

pattern confirms the setup the trade may be entered into. It is important that the price action during a

failure either touched the band or missed the band with a small margin. Failures not close to the band

will be worthless and may give false signals. The target of a trade like this will be the opposite band.

Notice that all three the setups will be trades that is against the prevailing trend. Finding trend reversals

early is made easy using Bollinger bands. Remember once a normal divergence appears no trend

following trades can be entered into and the expectancy of a trend reversal does increase. Using only

divergence in the South African market is just not enough. The Bollinger band setup gives a very strong

signal that the trend can reverse now, and that there is a potential wave - one to capitalize on. Once

wave one is formed a normal trend following strategy can be followed again making the best of the

trend.

Remember that a failure followed by a tag is not a valid setup at all, the order is very important.

Trade the normal trend following strategy until normal divergence is spotted, then usually no trade

would be done and the share will not be on the watch list until a full wave one played out. With

Bollinger added, a trade is now possible to get into a trade before the trend reversal was confirmed,

helping to capitalise on a wave one.

Until next time!

Johan Malan

Candle Reversal

Enter into trade

Indicator

Tag

Failure

Target

Divergence


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Bollinger Band Strategy