Bollinger Band Indicator
Bollinger Bands were established by John Bollinger in the 1980s. Bollinger Bands are comprised of the following bands:
• The upper Bollinger Band
• The moving average Bollinger Band or Middle Bollinger Band
• The lower Bollinger Band
The default settings for the Bollinger Band consist of a 20-period Simple Moving Average for the middle band and the bands are set at 2 standard deviations above and below the middle band. The purpose of Bollinger Bands is to give a relative meaning of highs and lows, measuring price volatility. The bandwidth increases when prices are volatile and narrows as the volatility decreases.
The Bollinger Band is useful for traders to help position themselves in the marketplace and under all market conditions. The advantage of the Bollinger Band is that it enables traders to detect price data between the lower and upper bands.
Stochastic Oscillator
Stochastic is an oscillator concocted by George Lane in the 1950s, which is comprised of two lines:
• The %K line
• And the %D line
The default settings for the Stochastic oscillator are 14-periods. The %K line is usually displayed as a solid line, which is a 3-period Simple Moving Average of %K. The %D line is usually displayed as a dotted line to act as a signal or trigger line. The Stochastic oscillates between vertical sizes of 0 to 100. While using the Stochastic, I prefer to use both, the %K and %D lines. The hypothesis behind this indicator is that it does not monitor volume instead it tracks speed or price momentum.
Therefore during an uptrend market, when the price is just close to its peak, the oscillator will be at its peak (above 80), indicating that the security is overbought. Conversely, when the price is close to its lows, then the oscillator has a tendency to move towards a low reading (below 20), which indicates the security is oversold.
The labels, however, can be somewhat rather confusing, as we cannot consider that overbought (above 80) will signal that prices will immediately drop, similarly with oversold (below 20) it should not be considered that prices will instantly turn to the upside. The terminology ‘overbought’ and ‘oversold’, is used to describe when prices are trading near the peak or trough of the period selected and in this case within the 14-day range. This situation can have a long-term effect.
Using the Indicators, Price Action and Timeframes
Most technicians will use Bollinger Bands or Stochastic as a basic method to settle on their trading decisions. I cannot consider it a fault, however, the root of the problem by applying a solitary indicator to settle on a trading decision is that it offers a different perspective from which to analyse the price action. The technical indicator consists of a number of data points that are calculated by setting a specific formula to the price data of a security. Any indicator or sign of what may happen later on is simply a probability, not a certainty.
The phrase that I like the most is: “Price Action is the best indicator as it is the study of the purest indicator and it is the one that will never tell a lie”. Price action is never misleading as it does not predict future price movements, but rather describes the past. Additionally, the price action reflects everything that is affecting a market at any given time and under all market conditions.
Therefore, with the help of technical analysis and some significant indicators, traders can shift the probabilities on their side, and here the price action could be turned into the most important indicator. Moreover, technical indicators are designed for short-term price movement analysis. Therefore, I use technical indicators to help identify high probability trade entry and exit points. To identify these entry and exit points, I always move towards lower timeframes.
Each specific market has specific designed trading strategies. Whilst creating a trading system, the trader will configure the settings (chart timeframe, indicator etc.) of the trading system accordingly, that is most suitable in the market. This suggests that each trading system has the appropriate default settings for that specific market, and if the trading system is going to be traded on different markets then these settings are adjusted accordingly.
Applying a Theory by using Bollinger Band and Stochastic
As we have already highlighted in the aforementioned, price action is the best indicator, as well as the need to also determine which timeframe and indicator settings mostly adapt and identify with our trading system. Overall we must have a perfect combination of these three to get the best possible result. The speed and price momentum are identified by the Stochastic indicator and acquire a possible price trend alongside with the Bollinger band which automatically detects the volatility measurement. I will go through a few illustrations below, however, I won’t reveal my secret formula. Keep in mind, there are numerous combinations which exist, some of which function most effectively in a specific timeframe, indicator setting and specific security.
Interpretation – Bull and Bear trade setups
It has been discovered that selling the breaks of the higher Bollinger Band is a way to take advantage of overbought conditions. Typically, once a higher band has been broken due to heavy buying, the price of the security will revert back below the higher band and head toward the middle band. I based my strategy on this theory, but I will use the Stochastic indicator as a trigger line to confirm my trading setup.
Interpretation: If the price action (bullish candlestick) closes above the upper Bollinger Band, which I consider to be the first signal, we can then move towards the Stochastic oscillator and wait until it breaks the 80 level to the downside. Once the break has occurred a short position can be taken, with a potential move towards the middle Bollinger Band. Simultaneously, we place our stop loss above the shadow of the candle which closed above the upper Bollinger Band. After withdrawing 75 percent of the profit, the stop loss can be adjusted to breakeven (in case the price turns against the trader). As the price starts to pull away from the middle Bollinger Band, and the price has penetrated the lower Bollinger Band, the remaining profit can then be withdrawn. Thus from the above example we have identified that the close price is of great significance when working with Bollinger Bands.
In the inverse situation we anticipate for a bearish candle to close below the lower Bollinger Band. Subsequently, when the Stochastic breaks above the 20 level, a long position can be entered, with a potential move towards the middle Bollinger Band, which is considered to be the first target. Consequently we are left with two options, to either close all positions or withdraw the 75 percent profit. If the second option is selected, the stop loss must then be positioned to breakeven when the price starts to pull away from the middle Bollinger Band. The remaining position should be closed when the price reaches the lower Bollinger Band.
In the first example below (Figure 2), let’s assume that we entered the market long at 1.2550, when the price evidently closed below the lower Bollinger Band and the Stochastic had exited the 20 level. Following that action, the price started to rise and reached the middle Bollinger Band around the 1.2630, our first target, following three positive candles. Moreover, the price continued moving to the upside and reached the upper Bollinger Band after six candles.
In the second example (Figure 2), the price managed to close below the lower Bollinger Band and slightly below the 1.2400 region. Consequently, the confirmation came from the Stochastic oscillator, which crossed above the 20 level, thus a long position can be entered. Following this setup, the price surged forming four consecutive winning candles and reached the first target (middle Bollinger Band).
Having locked the 75 percent of profits, the stop loss should be adjusted to breakeven in the event that the price moves against the trader. Subsequently, there was a pullback after the price tested the middle Bollinger Band, failing to break below the lowest shadow of the first candle, the one which closed outside the lower Bollinger Band. Instead, it started moving upwards again and after eleven candles it successfully reached the second target, meeting the upper Bollinger Band.
Conclusion
As I have discussed throughout, Bollinger Band should not be applied as a signal generating indicator, but rather in conjunction with an alternate indicator in which it proves to be extremely helpful. Thus, I prefer to use Bollinger Band and Stochastic collectively to generate possible buy and sell signals as well as to identify overbought or oversold areas. Furthermore it is important to emphasize that the most essential trading technique is the price action, which allows me to read the market and make informed trading decisions based on the actual price movement, rather than relying on a single indicator. There are numerous Bollinger Band and Stochastic strategic techniques, some of which work in the short-term, others in the long-term, but never one that is long-lasting.
