CMC Markets Trading Smart Series: Harnessing volatility

Harnessing Volatility with Bollinger BandsTHE CMC MarkETs Trading sMarT sEriEs

CMC Markets | Harnessing Volatility with Bollinger Bands 2

As a trader, you need to have a good understanding of the nature of market volatility and the way it impacts your positions. One of the most popular – and one of the most reliable – tools that traders have at their disposal is Bollinger Bands, developed in the 1980s and named after its creator, John Bollinger.

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What are Bollinger Bands?When it comes to watching price movements of any instrument that

you’re trading, it is very useful to have an understanding of where

price is trading relative to its average.

The moving average is a popular way of doing this, because it

demonstrates the average value of the instrument over recent

trading conditions. When you see the price above the moving

average you may think it’s bullish, and when it is below you may think

it’s bearish. What do you feel, however, if the price is a long way

above or below the moving average? And is it too far above or below

the moving average for you to still feel bullish or bearish? Maybe now

you want to be a contrarian!

Bollinger Bands add a further assessment of recent trading activity

by using a very powerful statistical measurement tool: the standard deviation. In essence, the standard deviation provides a value within

which the price has a probability of not moving further. A simpler way

to say this is that if the price moves outside the envelope formed by

the standard deviations, then it is quite a significant event. We will

look at this in more depth, but for now the key thing is recognising

that the envelope formed by the Bollinger Bands can be quite useful

in gaining an appreciation of how far price has moved away from its

average – and what you can do about it.

Before going any further, however, we need to look a little more at

standard deviation to help you gain an appreciation of what that

means to you as a follower of Bollinger Bands.

Harnessing Volatility with Bollinger Bands

Understand one of the key tools for any trader. Find out how to put one of the methods described by John Bollinger into practice. Gain an understanding of the limitations of Bolliner Bands, and what it really represents.

In chart 1, you can see a distribution, or bell, curve. This tells you

that based on the number of observations that have been taken

(for example, index prices over the last 20 days), 95% will occur

within +/–2 standard deviations of the moving average.

-4.0 -2.0 0.0 2.0 4.0

68 95 99

CHART 1 Two standard deviations covers 95% of expected distribution.


What does this distribution curve mean to you? It is of real

importance, because the Bollinger Bands are placed at a distance

of +2 and –2 standard deviations away from the moving average.

So if you don’t have any idea what the relevance of the standard

deviation is, you are not going to know what the Bollinger Bands

are telling you. The main thing to think about at this point is that

the envelope of the bands should contain the vast majority of

trading activity. Therefore, a move outside of these bands is, in

fact, a statistically very significant event. In this guide we want to

consider what you need to do when this occurs.

There are a large number of different ways in which traders interpret

this information. We examine one that was espoused by John

Bollinger himself.

You may also think that putting a fixed percentage amount as an

envelope above and below the price may be an effective way of

containing the majority of price movement. This may be the case,

but it lacks a crucial advantage of the Bollinger Bands: the fact that

The Bollinger Bands are represented by the three lines around the

price movements. The middle line is the 20-period moving average.

This is the default value of this component of the indicator. The

upper line is the value of the moving average plus two standard

deviations, while the lower line is the moving average minus two

standard deviations. You can see how these upper and lower bands

because the bands are based on standard deviations, they will widen

and narrow around the moving average depending on the recent

level of volatility that the price has demonstrated. This means that

the lower the level of recent price volatility, the narrower the bands

will be. The greater the recent volatility has been, the greater the

width of the range contained by the bands. Merely by looking at

the bands it is possible to get a very good idea of what the recent

trading conditions have been like for the instrument that you are

considering.

How Bollinger Bands apply to your trading

Now that we’ve looked at the composite parts of the standard

deviation, it’s time to take a look at the Bollinger Bands themselves

and how they apply to your trading.

A typical chart with the Bollinger Bands in place might look

something like chart 2:

envelope the price for the majority of the time. For traders who

use Bollinger Bands, the time of greatest interest is when the price

moves outside of the bands, because this is what would be referred

to as a statistically significant event. It is important to be able to

respond accordingly to the setups you are provided with.

CHART 2 Bollinger Bands adapt to changing market conditions.


CHART 3 Price movements outside the bands are statistically significant.

Chart 3 is simply a closer look at one of the components contained

in chart 2. You can see that when price starts to move very quickly

it moves outside the boundaries of the bands. What also adjusts

quickly is the direction and the width of the bands.

In general terms, when the instrument becomes more volatile the

bands move further apart. This is because the standard deviation

value increases. When the price moves in one direction consistently,

the moving average will gradually change direction to follow it. It is

for these reasons that the price generally will not stay outside of the

Bollinger Bands for very long: they adapt to keep price trading within

them.

The W formation

In this guide we are primarily examining a single methodology to

apply using the Bollinger Bands. However, to better illustrate its use

it is important to describe at least the groundings of another method

which can be employed at the breakout of the Bollinger Bands. One

of the books on the general topic, Technical Analysis by Kirkpatrick

and Dahlquist, leads the authors’ discussion with the following:

In line with the basic concept of following the trend, bands and envelopes are

used to signal when a trend change has occurred and to reduce the number

of whipsaws that occur within a tight trading range. While looking at the

envelopes or bands on a chart, one would think that the best use of them

might be to trade within them from the high extreme to the low extreme

and back. Similar to strategies for rectangle patterns, however, the trading

between bands is difficult. First, by definition, except for fixed envelopes

the bands contract during a sideways, dull trend and leave little room for

manoeuvring at a cost-effective manner and with profitable results. Second,

when prices suddenly move on a new trend, they will tend to remain close to

the band in the direction of the trend and give many false exit signals. Third,

when the bands expand, they show that volatility has increased, usually due

to the beginning of a new trend, and any position entered in anticipation of

low volatility is quickly stopped out.

What you can take away from this is that you shouldn’t try to use

Bollinger Bands in the same way as you might use some other type

of indicators that tell you an instrument may be overbought or

oversold. Instead, these bands show you when a new trend may be

developing, so you should generally resist the temptation of trading

against the direction of the initial breakout of the price through

either the upper or the lower bands. Some traders will look to this

breakout-type trade as a means of going long or short if the price

closes above the upper band, or short if it closes below the lower

band. The trade remains in place until the price closes on the far

side of the moving average line that runs between the two standard

deviation lines.

The main trading method that we want to discuss using Bollinger

Bands is one described by John Bollinger himself in his 2002 book,

Bollinger on Bollinger Bands. What you are looking for in this setup is

called a W formation. Bollinger describes several different variations

of the W formation in his book, but we will be looking at it in general

terms. The name of this setup provides a good idea as to the shape

of the price pattern that you are looking for: a W. The thing that you

need to put more thought into, however, is how this pattern then

interacts with Bollinger Bands.


CHART 4 The beginnings of a trade setup.

As with many setups, the W is one that can be used for trading on

either the long side or the short side. All the examples below can be

reversed and traded in the opposite direction where the initial setup

is the opposite, depending on whether you start with an uptrend or

a downtrend.

For our first example, we will start without the Bollinger Bands so

you can see the basic setup pattern to look for, in this case a strong

trending movement either upwards or downwards. In chart 4, you are

looking at a downtrend.

The point where the arrow is drawing your attention in chart 5 is the

first low. The key takeout from this is that the low point of this first

trend trough in the W formation is outside the Bollinger Bands (it is

also acceptable for the price to just touch the band). As discussed

earlier, this is quite a significant event considering how much of the

price action you would expect the two-standard-deviation envelope

to contain. You can see that the second trough is inside the bands.

The circled component of chart 4 highlights the W. This is where the

trend has bottomed and then retested after a short reversal, which

forms the pattern we’re interested in. The right hand low

can be higher than, equal to, or lower than the previous low. In

the next chart we take a look at the same setup, but add in the

Bollinger Bands because this enables us to measure how extreme

a movement we are viewing.

The Bollinger Bands are telling us that while the first trough has

a statistically high variance from the moving average, the second

trough – being inside the bands – does not. To a trader looking only

at price, the market still looks weak. However, a trader using Bollinger

Bands is being given a clue that the trend is losing momentum.

Changes in momentum often precede changes in trend and, used

judiciously, can be a useful tool for traders looking to get set early

in the life of a trend.

CHART 5 Overlay the pattern onto the Bollinger Bands.


Buy

Second trough in the W. Note that the candle low is inside the lower Bollinger Band and surrounded by two higher lows.

CHART 6 The formation of the second trough is the key signal.

Once the pattern forms the second trough, as in chart 6, you will look

to make an entry into the trade. The way to know that a trough has

been formed is when the instrument being traded closes above the

Chart 7 presents an example of a trade that would trigger as a short

position. In this case you are looking for an M formation. It pays not

to be too precise in looking for a perfect M. The two peaks can be

quite lopsided, with the second one quite a bit higher or lower than

the first. The key thing is that the price on the first peak has moved

highest point of the candle that made the lowest low (that is, the

lowest point of the trough). You should wait until it has closed at this

level so that you have confirmation of this W formation.

outside of the Bollinger Bands and the second has remained within

them. This demonstrates weakening deviation from the mean, even

where the second peak is quite a bit higher than the first.

This is a very useful trade setup for a wide range of different

markets and timeframes.

CHART 7 The same pattern reversed can give a good short trade.


1st stop2nd stop

3rd stop

4th stop

Final stop

CHART 8 Place your stop at the first point you know a reversal has occurred.

In the case of chart 8 your first stop could be placed above the high

point of the second peak in the M. The rationale for this should be

quite easy to see: if the price reaches this level the pattern is no

longer valid, so you have no reason to remain in the trade. Some

traders will allow some tolerance above the peak to reduce the risk

of being stopped out on a false break of the resistance. You will

want to trail the stop lower as the trade continues to move in your

favour so as to take the opportunity to lock any potential profits. You

can see on the chart that one way of doing this would be to place

the stop above each new corrective peak in the downtrend as it is

subsequently formed.

Review • Youshouldunderstandwhatstandarddeviationmeans

andhowtoapplyitaspartoftheBollingerBands.

• Youshouldbeabletosearchfortradesetupsandbeable

todeterminewhicharesuitableandwhicharenot.

• Youshouldbeabletoeffectivelymanageyourriskthrough

applyingasensiblestoplossstrategy.

Bollinger Bands and stop loss

As with any trade you make, you should have a very clear picture of

where you place your stop loss. As something of a side note, you

will likely find all of your trading becomes much more relaxing when

you take on a sensible stop loss strategy, because you have then

quantified your risk. Trading can be stressful for traders who have

no plan as to when they will exit a losing trade. Sensible traders will

know up front where they will place their stop and how much they

will have at risk before they even enter the trade rather than trying

to make their strategy up on the fly.

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CMC Markets Trading Smart Series: Harnessing volatility

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Transcript of CMC Markets Trading Smart Series: Harnessing volatility