Bollinger bands can be used with Stochastic and RSI to spot emerging patterns and enable you to take an advantageous trading position. Between these tools, you can take advantage of bearish and bullish patterns as they emerge to decide when to enter and exit specific markets.
Bollinger bands can be excellent indicators of what will happen next in a particular market, and while they generally work best in a sideways market, they can give an excellent indication of when a breakout might take place. It is a common technical indicator that can be used with others to find winning trends.
Bollinger bands close up when the market is stable and widen with increasing volatility. When price movement is sideways, Bollinger bands can be used along with stochastic indicators to indicate good entry points. Because volatility in any market indicates change, and a potentially large move in the market, there are some aspects of Bollinger bands that we should be looking for. Let's see how to interpret Bollinger bands, and also how to use them with other technical tools:
When Bollinger bands widen, the market is becoming more volatile. You should expect that if a price is moving upwards, then it can be expected to continue to increase. However, you must be very clear about the direction the volatility is taking.
A1: Bollinger Bands Widening (Bullish change)
Bollinger bands tend to widen after a period of tight bands with shorter low volatility candles with some range movement. The upper and lower bands are diverging sharply with an upward price movement and the recent candlesticks are longer than those previously. The action to take is:
a) Check the Relative Strength Index (RSI). Is this at 30 to 50 and rising?
b) Is the Average Directional Index (ADX) increasing to and over 25 with the +DI crossing the -DI?
c) Is the 'slow' stochastic line crossing upwards over the signal line?
If each of these is taking place, then you have a 'buy' situation because the price should continue to move upward. You might want to wait for another 2 or 3 candles to establish the trend and then decide to buy, but don't be fooled if there is any slight downward movement - that is likely just a correction, and the trend should continue upwards.
If the ADX does not go over 25 as expected, then perhaps the move upwards is going to be less than hoped for, and while you can still take profit, it will be less than you thought. However, profit should still be there.
A bearish change occurs after a similar pattern to a bullish change, the difference being that the price action is moving downwards below the middle. In this case:
a) Check the RSI - is this between 55 and 75 and falling?
b) Check if the ADX is increasing up to or beyond 25 with the -DI line crossing the +DI line.
c) Is the Stochastic Line crossing downwards over the signal line?
In this case the move should continue downward, but before taking a short position wait for another 2 or 3 candles to confirm the trend. As before, there might be a short period of correction before the downward trend continues, and perhaps waiting two or three more candles will set your mind at rest that the trend is genuine. However, this might be a limited downward movement if the ADX fails to rise above 25, again leading to lower profits.
The tighter Bollinger bands become, the less volatile the market. However, because these bands do not remain tight forever, they indicate an opportunity that can be seized if you can predict when they are going to open up again. Bollinger bands squeeze normally indicate an upcoming volatile move like the silence before the storm.
B1: Bollinger Bands Squeeze - Bullish Change
A bullish change occurs when there is a sideways move with the tightening lower volatility bands associated with short candlesticks. To confirm this change, you should:
a) Make sure there are at least two continuous green bullish candlesticks that are longer than the previous two to three candlesticks.
b) Check that the RSI is from 30-50 and rising, and perhaps also that the ADX is increasing to 25 or over and that the +DI is crossing -DI.
c) The stochastic (slow) is crossing upwards over the signal line.
If these are taking place, then you can expect an upward breakout, although you might want to wait for 2-3 more candles to be sure before assuming a buy position with a red candle.
Is ADX moves up below 25, then the upward move might be limited with a corresponding limit to the profit taking.
A bearish change with tightening Bollinger bands takes place under similar conditions to B1 above, only look for:
a) Two continuous red candlesticks that are longer than the previous two to three,
b) RSI is falling within the range 40 - 60, and the ADX is increasing to 25 or over and -DI is crossing +DI.
c) The slow slow stochastic is cross downwards over the signal line.
Again wait another 2-3 candles to be sure before you take a sell position, and again there will be a limited profit taking if the ADX fails to move over 25.
It is possible for the price to revert to the middle band during an ongoing upward trend, or even to the lower band. If that is the case, then carry out the checks b) and c) as in situation B1 above. If everything is fine, then you can expect the uptrend to continue. Again, before taking a buy position, it will be safer to wait for 2-3 candles for confirmation that the change you noticed was just a correction and that the trend is now continuing upwards.
As with A3, a temporary reversal can occur during an ongoing downtrend. As above, check the items a), b) and c) in A2 above. If the bearish configuration is still OK, then the downtrend should continue after the brief correction. To be certain, wait another 2-3 candles for confirmation of this, and then take a sell position.
Bollinger bands are very useful in giving you an indication of future trends, particularly when used in conjunction with the stochastic oscillator, and any trend that tends to break out of tightened Bollinger bands will be highly likely to continue that trend, while any trend threatening to break out of widened bands will tend to bounce back to the middle. These are not hard and fast rules, but worth remembering.