Education: How to use the Bollinger Bands According to research, breakout-style trend-following trading systems like the Bollinger Bands are among the most reliable. But few actually understand how to use the Bollinger Bands as a complete trading system. The most valuable use of the Bollinger Bands is how the help to visualize volatility, or a lack thereof. Low volatility: When the Bands tighten or narrow, it suggests a low volatility state. An analyst can strategize around this a variety of ways. In the red shadow box, we can see that the Bollinger Bands spend over a year at record tightness. During that time, there was a lack of a trend and primarily sideways movement. It is during this phase where the Bollinger Bands can be used as a mean reversion trading system, selling touches of the upper Bollinger Band and buying touches of the lower Bollinger band. At one point during the red box, price closed outside the lower Bollinger Band, generating a breakdown sell signal. However, price immediately reentered the Bands suggesting a range deviation and not a valid breakdown. A low volatility state is referred to as a "squeeze". The other useful strategy around it is to watch for a breakout or breakdown above/below the upper/lower bands, followed by rapid expansion of the Bollinger Bands. Traders can better prepare and anticipate a big move using this method. A great example is XRP on the monthly scale that I've referred to in earlier posts. High volatility: When the Bands begin to expand rapidly, it signifies a switch to a high volatility state and a trending environment. This is when the Bollinger Bands work best as a breakout-style trend-following trading system. The Bollinger Bands are based on a 20-period simple moving average and two bands set at +2 and -2 standard deviation. Moves outside of a +/-2 deviation take a lot of strength, so a close above the upper Bollinger Band or a close below the lower Bollinger Band generates a buy and sell signal respectively. Moves that close above or below the upper or lower Band have the highest probability of turning into a sustainable trend. During this phase, price will "walk the bands" as is highlighted in the green shadow box. Closing back inside the bands means it is time to take some caution. A buy position is closed when price closes back below the Bollinger Band basis. A sell position is closed when price closes back above the Bollinger Band basis. Tips: Look for additional confirmation to help support buy or sell signals. For example, a close above the upper Bollinger Band with high green (bullish) volume and the RSI moving above 70 has a higher probability of turning into a sustainable trend than if there was low volume and the RSI was at 30. Bollinger Band Width, a spin-off tool, further helps visualize how tight or wide the Bollinger Bands are by turning its measurements into an oscillator.
