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HOW TO USE BOLLINGER BANDS TO FIND SOLID TRADES

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Options Trading Strategies Jan

27
2014
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Bollinger bands, named for its developer John Bollinger, are measures of volatility shown by bands that are
deviations above and below a relevant moving average. The bands expand and contract as volatility increases
and decreases. In this article, we’re going to talk about how to use Bollinger bands to find solid trades.

What are Bollinger bands?

Take a look at this chart on the right; the Bollinger bands are shown in
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The bands are typically calculated from the 20 period simple moving
average. This value is shown by the dotted blue line. The upper and
lower Bollinger bands are calculated by taking the 20 day simple
moving average (standard deviation of price) times 2. (I’ve used the
word “period” because one of the great things about Bollinger bands is
that they can be used for any time frame.)

Bollinger bands contain 90% of all price action, so it is very useful to

know where price lies within the Bollinger band complex. Stocks with
price in the top portion of the Bollinger band complex are stronger
than stocks with price in the bottom.

I relate price within the Bollinger bands as residing in the penthouse (upper) or the abandoned warehouse
(bottom). I want to own penthouse stocks. By watching price movement within the Bollinger band complex,
you can easily determine a behavior change in the underlying, thus making it possible to be proactive vs.
reactive.

Let’s break that concept down a little bit with a few practical applications.

How to use them to find solid trades

Below is a W bottom, one of the most easily recognized and stable price patterns to trade. A W bottom is a
bullish price pattern that forms when price is in a downtrend.

The left side of the W is formed when price falls to a reaction low – in a lot of cases, it is outside the Bollinger
bands. Keeping in mind that the Bollinger band complex contains 90% of the price action, when price violates
 the Bollinger bands, it usually reverts to the mean price – price goes back
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When this is happening you can see the candle making a very long wick
on the bottom. Generally speaking, when you see a long wick after an
extreme move, you trade in the opposite direction of the wick. If you
catch it forming the wick at the extreme, you have a high probability
trade with a target back inside the Bollinger bands.

The middle of the W is formed when price tries to rebound, but is

rejected at a prior price level, or a moving average. This is commonly
referred to a “dead cat bounce.” The rebound towards the middle
Bollinger band typically happens on lowered volume. Usually, the top of
the middle is identified with a doji or a spinning top candle, both of
which indicate indecision of buyers willing to hold the underlying at or
above the current price level.

The right side of the W is formed when price is rejected at the most recent high and falls down toward the
bottom Bollinger band to a second reaction low. Confirmation of a true W bottom happens when price
attempts to retest the first reaction low, but the real body of the candle stays inside the bands, evidence that
the second reaction low was weaker than the first. Again, you can watch the candle formation to see that a wick
has formed to the downside, and you can take a high probability trade.

Trade opportunities in a W pattern

There are three trade opportunities within each W formation (refer to the circled areas).

1. The reaction low is a high probability trade taken when the candle forms on very high volume with a very
long wick at the bottom. Traders can enter the trade when the candle starts to form a real body, no matter
 what color the candle is. The trade is then maintained with the first target, the
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second target is the middle or top of the Bollinger band complex.

2. The rejection of price at the most recent high (middle or upper Bollinger
band) is shown with circle 2. In this example the candle has printed black
(black = warning). Black candles form when price closes lower than at open. In
addition, candles with longish top wicks often precede the reversal candle.
This trade is a little trickier, as you have to wait for confirmation of a top by the
next candle, or the next few candles. Traders can enter short with the piercing
of the middle band with a target very near the first reaction low. The key to
successful rejection trades is not to stay too long. Pick your price target
slightly above the bottom Bollinger band and set a buy to cover that is good
till canceled as soon as you enter the trade.

3. The second reaction low is the candle sequence that forms a higher low, at the right side of the W. This is the
most powerful move of the price pattern and is formed on high volume pushing price past prior resistance
points. This trade generally goes on to make new highs and is the move that frustrates many traders. Traders
can enter long when the price forms a long clear candle that surpasses the prior relative red (sales) candle.
This trade is managed by use of a trailing stop, as price generally goes on to make new highs (savvy traders
don’t pick tops).
Traders are frustrated by this price pattern, because they experience a draw-down, followed by a bounce, only to
draw-down again. A large number of traders buy at the peak of the dead cat bounce and sell at the second
reaction low only to watch price rebound and go on to make new highs. In other words, they buy circle 2 and
sell circle 3. You can avoid this trap!

By identifying this candle pattern, traders can become aware of the bottoming process and the price action
within. Fully aware traders are proactive traders, and proactive traders make controlled, high probability
decisions. High probability decisions result in stable portfolio growth.
I challenge you to review your worst trades to see if the W formation was forming at the point you took action.
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Category: Options Trading Strategies By Explosive Options January 27, 2014 1 Comment

Tags: Bollinger Bands chart patterns volatility

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