Using Bollinger bands to produce trade signals

The Bollinger band tool helps provide both reversal and breakout signals. This article highlights how such signals can be utilised alongside price action to provide strong trading signals.

Source: Bloomberg

The Bollinger band is a commonly used technical indicator that can provide a number of different signals and pieces of information to traders. Falling into the bands and channels category, the Bollinger has the benefit of taking place on the price, rather than separate from it, thus providing dynamic support and resistance. That dynamic support and resistance element provides one of the most important functions of the Bollinger band, with the vast majority of price action taking place within the upper and lower limits.

Bollinger rejection

The Bollinger rejection takes place when the price unsuccessfully attempts to break through the upper or lower limits of the Bollinger, instead choosing to reverse towards the middle band – the 20-hour simple moving average (SMA) - or lower threshold of the indicator.

Looking at the chart below, we can see a two month period of time where Brent crude utilised the Bollinger to great effect. The move into that consolidation started with price action piercing through the upper Bollinger band on three consecutive days, highlighting the willingness to operate within a more trending phase. The break back into the bands, with the fall below the 20-hour SMA highlighting the fall out of a trending phase and into a period of consolidation.

From there, we saw two months of tightening price action, with both support and resistance being supplied by the indicator over a period of two months. This provides a host of buying and selling opportunities within an intraday basis. The breakout from this phase is clear cut, with the price closing well outside the lower Bollinger band. However, the critical secondary element of the breakout comes with a closed candle below the $54.54 swing low. Just like how the initial uptrend is signaled by a strong close above the upper band, we have now seen a bearish signal come via a close below the first major swing low out of the symmetrical triangle formation.

Bollinger squeeze and break

The width of the Bollinger band provides a trader with an idea of how volatile the market is at any given time. A wider range between the two outer bands means we have a volatile market, while a more muted market would see the bands tighten. That tightening can be viewed as a coiling effect, with a period of low volatility often giving way to a sharp jump or fall in the price.

Much in the same way as a spring will coil up prior to release, a tight Bollinger band can provide a precursor to a rapid acceleration in volatility. Much like the example above, the key here is whether we see a confluence of other signals that provide support to the notion that the Bollinger is telling us. With that in mind, it pays to be aware of what price action is saying. For while a tight Bollinger band could precede a breakout, the wider context provided by the price will let us know whether that spike in volatility could carry some sort of longstanding implications.

Looking at the GBP/USD chart below, the uptrend is clearly defined, with the price hitting higher highs and higher lows, set within the middle (20-hour SMA) and upper Bollinger Band.

The break below the $1.9654 swing low in early 2008 provided the first bearish signal, which led to the price trading primarily within the lower half of the Bollinger band. That provides the precursor to a potential bearish reversal for this market. From there, we saw the bands start to squeeze, heightening the chance that the price will break out. Once that move happens, the sell signal comes with a close candle outside of the bottom band and below the $1.9337 low.

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