How to Use Bollinger Bands in Forex and Stock Trading

Category: Forex Basics | Sunday, February 1st, 2009

Bollinger Bands are the second indicators I use after the candlesticks. In fact the combination of candlesticks and Bollinger Bands makes the signals for me.

There are some awesome features in the Bollinger Bands that can not be found in the other indicators. Before talking about the signals lets see what Bollinger Bands are and how they look like. If you don’t have them on your chart, please add them and let the setting to be the default setting which is 20.

Bollinger Bands are consist of three lines: Bollinger Upper Band, Bollinger Lower Band and Bollinger Middle Band.

Bollinger Middle Band is nothing but a simple moving average. Bollinger Upper and Lower Bands measure deviations. I can bring their formula here but it will not have any usage for your trading. The only thing we should know is that they are so strong in diagnosing the trends and reversals.

Note: In all the below examples, the Bollinger Band setting is the default setting which is 20 period and 2 deviations.

So how can we use Bollinger Bands in trading? What do they tell us and how their signals look like?

1. Trend Trading:

One of the most important features of Bollinger Bands is that when the market is slow and there is no reasonable volatility, the upper and lower bands become close to each other:

As you see on the above image, Bollinger upper and lower bands have become so close to each other in the area that I have placed those white arrows. Keep in your mind that when the market becomes slow like that and it makes a narrow range a breakout that can be the beginning of a big trend is on the way. You can easily predict the direction of the breakout with the signals that the market already has shown. Just follow the numbers at the above image and you will see what I mean.

The candlestick #1 has a long lower shadow. What does that mean? It means a big Bullish pressure is imposed to the market suddenly. So the price wants to go up. This is the first signal. You could take a long position after this candle but if you did not, the market would show you some more signals to go long. After candle #1, market becomes slow and Bollinger upper and lower bands become so close to each other. Candle #2 shows a breakdown with the Bollinger lower band but it is closed above it. This candle also has a long lower shadow that reflects the upward pressure. Then the market becomes slow for several candles BUT candle #3 assures you that the range is broken up. So if you didn’t have a long position, you could go long at the close of #3 candle. Then some red candles are appeared but you should know that after a range breakout, the very first reversal signal is not in fact a reversal signal. It is a continuation signal.

The above breakout could be the beginning of a big trend but it is not. I just brought it here as an example of ranging and breakout. If the candlesticks movements make you confused, you can shift to the line chart from time to time and find the real support and resistance of the range. Line chart is plotted based on the close signal. Close signal is the most important thing specially when you want to interpret the signals with Bollinger Bands and predict the market. Lets shift to line chart and see how it looks like:

As you see the support and resistance of the range are shown much better in the line chart (blue circles). Numbers 1, 2 and 3 are where the candles #1, #2 and #3 formed on the last image. In the above line chart the range breakout is conformed while candle #3 was forming. The price line goes up, touches and rides the Bollinger Upper Band. This means the range is broken up and we have an uptrend.

So we learned that the close price is very important when we work with Bollinger Bands. A Bollinger Lower Band is not broken down as long as the candlesticks are closed above it and a Bollinger Upper Band is not broken up as long as the candlesticks are closed below it.

Like the Fibonacci system I explained earlier, one of the ways to trade using the Bollinger Bands is finding a range and then waiting for its breakout.

Bollinger Bands are really good in trend following. Please follow the numbers in the below image. #1 shows a good reversal signal (I will talk about the Bollinger Bands reversal signals later in this article). If I wanted to take a long position I would wait for more confirmation which is the #2 candle. I would go long at the close of #2 candle.

The next a few candles break up the Bollinger Middle Band and the candles after them make a small ranging BUT as you see all of them are closed above the Bollinger Middle Band (zone #3). Some of them tried to break down the Bollinger Middle Band but they couldn’t. What does that mean??? It is another confirmation for the beginning of an uptrend. Zone #3 is the most important part of the below image. More conservative traders prefer to take their long positions after formation of such a confirmation. They go long when the thin red line is broken up (#4). They place the stop loss below the low of the last candle that its shadow is broken down the Bollinger Middle Band. As you see it goes up strongly (first red big arrow). There are some small red candles but they should not be considered as reversal signals. At #5 the price goes down to retest the Bollinger Middle Band. This is the beginning of the second Elliott Wave. It is where some traders wait for the retrace (continuation) to go long. I have explained it in another article I wrote about Fibonacci.

Can you take a short position at #5 ? You can but you’d better not to do that. It is against the trend direction and when you see the price has been going up strongly and for a long time, you should ignore the first and even the second reversal signal. They are not reversal. They are continuation signals in fact.

So the price goes down, retests the Bollinger Middle Band and it even succeeds to break down the middle band but keeps on going up again. As I have explained above, although it could break down the middle band we should not go short.

It starts going up again (#6) and the next candles are all closed above the Bollinger Middle Band. Fibonacci can be a big help here. As you see at #7 and when it wants to break above the 100.0% level, it shows a bearish reaction but the next candle is closed above the Bollinger Middle Band and the next candle break up the 100.0% level (#8). We should expect that it breaks above the 161.80% level because it is a strong trend and as you see it can even reach the 261.80% level (#9) and break above it (#11).

Both when the uptrend is started seriously (#4) and when the 100.0% level is broken up (#8), candles touch and ride the Bollinger Upper Band. It is the same as when we have a downtrend. Candles touch and ride the Bollinger Lower Band.

2. Reversal Trading:

Bollinger Bands are great in showing the reversal signals too. Usually a nice reversal signal becomes formed when a candlestick breaks out of one of the Bollinger Upper or Lower Bands and then it is followed by another candle which has a different color. One of the best examples can be seen in the above image at #1. I am going to make the signal bigger and show it once again here:

As you see the candlestick #1 which is a bearish candlestick is formed completely out of the Bollinger Lower Band and the next candlestick (#2) which is a bullish candlestick has covered the body and upper shadow and also most of the lower shadow of candlestick #1. These two candlesticks form a signal which is called Piercing Line. A Piercing Line which breaks out of the Bollinger Band is much much stronger. A Piercing Line is called Dark Cloud Cover when it happens at the top of a pick. I strongly recommend you to learn the candlestick signals.

Here is some more reversal signals:

A long upper shadow that has broken out of the Bollinger Upper Band strongly

Bullish Engulf
Note how both candlesticks broken out of the Bollinger Lower Band and how the second candlestick has covered the first one totally.

Dark Cloud Cover
Note how both candlesticks broken out of the Bollinger Upper Band and how the second candlestick has covered the first one.
Also look at the big upper shadow that the second candlestick has.

False Signals:

We can always see some false signals. True signals are easier to catch because they are strong and obvious. A good trader is someone who can distinguish and avoid the false signals.

There are false range breakouts and also false reversal signals. Those who like to trade reversals will be encountered with more false signals because a trend can be continued for a long time and it is not easy to say when a reversal happens. If you like to avoid being trapped by false reversal signals just ignore the very first two reversal signala when there is a strong trend. Of course if you really wait for a big and strong breakout and you don’t rush to take a position when you see a weak and partial breakout you will have less number of false reversal. For example some traders take a short position when they see the below signal but as you see this is not a strong signal in comparison to the signals I showed above:

Why is the above signal a false signal?

1. The uptrend is a strong uptrend and this signal is the very first reversal signal. What do I mean by strong uptrend? Look at the uptrend slope. It is a sharp slope that is going up strongly. There is no sign of exhaustion in it yet. A trend should show the exhaustion signals to tell us that reversal is close.
2. Although about 50% of both #1 and #2 candlesticks are placed out of the Bollinger Upper Band, this can not be considered as a strong signal because

Both candles are not long enough and are relatively short candles.
They don’t have any big upper shadow that reflects the power of a downward pressure.
The second candle is very short and the first candle is not covered by it strongly.

Can you mention any more reason?

Here is two other examples for such a false reversal signal:

Can you say why those signals are false signals?

The third signal can be known as a relatively true signal because the uptrend is still strong. Look at the Bollinger Middle Band Slope (the first red arrow). So the trend is still strong and has not formed any sign of exhaustion when this relatively true signal was formed. However you could take a short position but you really had to get out when the continuation signals formed around the Bollinger Middle Band.

Now look at the below image and follow the numbers. Find out why some signals are false, some are true and some are continuation.

As you see Bollinger Middle Band works very well with continuation signals. In an uptrend, continuation signals are formed when the candles go down, retest the middle band and then start going up again. In a downtrend, continuation signals are formed when the candles go up, retest the middle band and then start going down again. Taking the continuation signals are much safer than reversal signals unless you make sure that the trend is really close to reverse.

Ok! Hope you find this article useful for your trades. If you have any question please use the below comment form. Thanks!

Further Reading:

37 Comments:
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Comment by sabams

2009-02-02 04:03:37

NICE ARTICLE BUT I STILL NEED MORE ENLIGHTENMENT ON THE TRUE REVERSAL SIGNALS. I CANT DIFFERENTIATE THEM PROPERLY