The Bollinger Band Is One Most Popular Short Term Trading Indicators
Today I'm going to show you how to use one of my favorite short term trading indicators to determine market conditions and market direction. The Bollinger Band was invented by John Bollinger in the early 80's. It is mostly widely used as an indicator to locate overbought and oversold market conditions. It quickly became one of the most popular short term trading indicators.
Today I will show you a different more robust use for this indicator. Before I get into how to use the Bollinger Band, let me explain to you exactly what it is.
The Bollinger Band consists of three parts: A simple moving average and TWO standard deviations of this moving average, this is known as the upper and lower band. Most traders use the Bollinger Band to trade trend fading strategies; these are reversal strategies that occur when the market tops out temporarily.
The idea is to sell when the price reaches above the upper band and to purchase when the market gets below the lower Bollinger Band. The Bollinger Band works very well for fading trends when the market is range bound and choppy. However, when markets are trending strongly, using the Bollinger Bands for picking tops and bottoms is highly discouraged. Many traders make this mistake and end up paying a hefty price for using the Bollinger Band in strong trending markets.
Although, I do use the Bollinger Band for fading market trends, when market conditions are appropriate, I tend to use it more as a filter to determine if the market is in fact range bound or trending. I find that using the Bollinger Band to determine market direction and whether the market is in fact trending the best use for this indicator. This helps me decide exactly what indicator to use to proceed with the entry conditions. The Bollinger Band comes standard on every charting program online and offline, so you don't have to worry about finding it and calculating it, the hard work is done for you.
The settings that John Bollinger, the inventor of the band recommends is 20 days for the moving average and 2 standard deviations for the upper band as well as the lower band. I tend to use a 14 day period instead of the 20 day period because I find that the shorter length for the moving average provides better indication for short term trading moves. I don't bother touching the standard deviation levels because they work very well without any adjustments.
Now that you adjusted the moving average time frame, I will show you how to analyze the Bollinger Bands to determine if markets are trending strongly upwards, strongly downwards or range bound and moving sideways. To determine a strong uptrend you want to see the upper band moving sloping upwards and each trading bar coming within a close distance, touching or slightly penetrating the upper band as well. Here is a good example so you can see how this looks visually.
Below you can see a good example of how the Bollinger Bands catches a strong downtrend as well. Notice the slope of the lower band and how the prices are gravitating towards that band. This is a good sign that markets are headed sharply down, you can also see at one point the band is flattening out and market is becoming range bound and flat as well. This is what makes the Bollinger band one of the best short term trading indicators, the ability to analyze market conditions in volatile and flat markets.
Below you can see Microsoft Corporation during a trend-less choppy market conditions. The bands are flat and the majority of price action is contained inside the bands as well. This is a good example of a flat market that is range bound and not moving in any particular direction.
There are several ways your trading can benefit from using Bollinger Bands to determine market direction. If you are trading a breakout or a trend following strategy, you can use this method as a filter to confirm that market is in fact trending strongly either upwards or downwards. If you are trading a flat market strategy or a reversal strategy you can use this method as filter to confirm that the market is in fact flat.
Many traders use the Bollinger Band as an entry or exit indicator but forget that it has several additional benefits, such as a filter to determine market direction. The Bollinger Band remains one of the best short term trading indicators, however many traders only use the band to determine overbought and oversold levels.
By using the Bollinger Band as a filter to determine market conditions and market direction you will avoid trading trend following strategies during dull flat market conditions and avoid picking tops and bottoms during strong trending market conditions.
During the next few weeks I will be profiling additional short term trading indicators and creating a system with those indicators in real time. So stay tuned.
All the best,