Bollinger Band Squeeze Trading Strategy
We will be examining how to use the Bollinger Band squeeze is a trading strategy including the rules that guide the strategy. We will start by quickly looking at what Bollinger Band is all about. Firstly, it is a popular tool with traders across all types of financial markets due to its versatility. Bollinger band is a trading tool that features a group of trendlines. These trendlines are plotted two standard deviations (both positive and negative) away from the simple moving average of an asset’s price. In other words, the trendlines are plotted at a standard deviation level over and under the simple moving average of the price. The trendlines are also referred to as bands.
Bollinger Band is a technical indicator that functions to measure volatility. It achieves this by helping to measure the high or low of an asset’s price relative to prior price movements. The Bollinger Band is an excellent indicator of volatility because the distance between the trendlines is based on standard deviation. This makes it possible for the Bollinger Band to adjust to volatility swings in the underlying price of an asset.
Bollinger Band utilizes two major parameters known as standard deviations and Periods. These parameters have default values: standard deviations = 2 and period = 20. But you can always customize the values to suit the prevailing market condition. Since standard deviation is used to measure volatility, it makes it easier to observe and pinpoint price actions in the market. Therefore, when the price rises, the trendlines of the Bollinger Band get wider and they become narrower when the price drops. This dynamic nature of the Bollinger Band makes it useful across a wide range of financial markets.
The Bollinger Band consists of the lower band and upper band which is used in pairs along with a moving average. The Bollinger Band was developed by John Bollinger, a trader with a vast amount of experience in the financial markets. At first, he developed the tool for use in stock trading. But as the years went by, traders began to realize its usefulness in other financial markets, such as the forex market. It can also be used across different kinds of timeframes.
Through the critical evaluation of price behavior in the market using Bollinger Band, a trader can set up trade entry signals for a specific asset. This is because the Bollinger Band helps traders to identify scenarios that indicate when an asset is undergoing overbought or oversold conditions. Traders can then capitalize on the trading opportunities made available by the Bollinger Band.
How the Bollinger Band Works
We pointed out earlier that the Bollinger Band comprises the lower band and upper band. These two bands are crucial aspects of using the Bollinger Band because they serve as an indicator of prevailing market conditions. Below are the different ways in which the Bollinger Band works.
- When there is a very large distance between the upper and lower bands, volatility rises. This may be a signal that any current trend is coming to an end.
- Whenever the upper and lower bands tighten during a time of low volatility, it increases the possibility of a sudden price move in either direction. This might lead to the commencement of a trending move. But be mindful of a false move in the opposite direction which reverses before the start of the real trend.
- Price can exceed or hover around a band envelope for extended periods during strong trends. It might be ideal to use a momentum oscillator in this scenario and undertake extra research to know if it is prudent to strive for more profits.
- When the price moves out of the bands, there is an anticipation that a strong trend will continue. However, if the price moves back into the band instantly, the expected strength becomes void.
- Prices tend to bounce within the envelope of the upper and lower bands in which they touch one band before moving to the other band. These price swings can then be used to pinpoint possible profit targets. For instance, if the price should bounce off the lower band before crossing over the moving average, the upper band is then the profit target.
The Bollinger Band Squeeze
What is the Bollinger Band squeeze? This refers to a situation in which the outer bands of the Bollinger Band become narrow. It is given this name because once the bands start to get narrow, the price also begins to get squeezed. When this happens in the market, it is visible to the trader.
The chart below shows the area where a Bollinger Band squeeze occurs. Charts make it very easy to observe how the contractions and expansions take place on the Bollinger Band.
In the chart, the upper and lower bands tighten as the range of price actions begins to drop. This usually occurs when there is a consolidation of markets which leads to the establishment of a sideways range. The chart below shows what happens in a Bollinger Band expansion.
From the chart, it is clear that when the expansion of the outer bands occurs with movement in the opposite directions, the price rises suddenly. This shows what a breakout looks like immediately after the Bollinger Band squeeze.
We can now see that the Bollinger band squeeze trading strategy is for initiating a trading position before a breakout occurs. Once the price consolidation comes to an end, traders can then take the ideal position (long or short) on a specific asset.
Volatility Expansion and Contraction
To truly appreciate the structure of the Bollinger Band squeeze trading strategy, it is necessary to understand the significance of volatility in financial markets. Volatility is seen as the occurrence of mean reversion in financial markets. In other words, volatility points to the presence of a notable ebb and flow in the markets.
Prices generally move from periods of low volatility to periods of high volatility and since it is a cyclical process, it is always present in the market. Understanding this fact can provide traders with an edge in the market. This is because it is much easier to predict the tendency of markets undergoing this cycle of volatility than the actual direction of market movements.
Since it is more difficult to predict the possible direction of prices than the volatility cycles, the Bollinger Band volatility breakout is thus ideal. It is well-known that markets do not move in a single direction every time. There will always be periods of trending in the markets before periods of sideways movement take over.
The order flow is always shifting from spheres of price equilibrium or balance to periods of trend movements or imbalance. This is a phenomenon that is ever present in the market irrespective of the selected trading timeframe. This up and down movement is seen in both the shortest timeframe and the longest timeframe. This is due to the irregular nature of the markets which causes the self-repeating patterns of market volatility to occur across all degrees of trend.
This market volatility is what the Bollinger Band squeeze strategy is designed to capitalize on and provide trading opportunities to investors. The Bollinger Band enables traders to track the overall volatility of a particular market. This makes it easy to observe the areas of volatility thus leading to the identification of profitable trading opportunities.
Trading the Bollinger Band Squeeze
The Bollinger Band squeeze trading strategy is applicable via simple trading rules. The first rule is the identification of areas of consolidation by noting the contraction or narrowing of the bands. After identification, the next step is the plotting of horizontal lines. This should be followed by marking the high and low end of the range that is present within the squeeze. After identifying the price levels, wait for the breakout.
Traders need to be aware of the possibility that the breakout can occur in any direction. This is why traders need to be certain of the direction in which the breakout will occur. Once this becomes clear, a trading position can be entered in the direction of the breakout.
Another factor that traders need to be aware of when using a breakout strategy like the Bollinger Band squeeze is a fake breakout. A fake breakout occurs when the price appears to be breaking out in a certain direction, only to turn around and move in the other direction. Fake breakouts are common to trading strategies such as Bollinger Band squeeze which are based on breakouts. This is why experts recommend that traders are sure of the breakout direction before entering a trading position. Let us now examine how to determine the direction of a breakout so that you do not get caught up in a false breakout.
Determining the direction of a Breakout
Based on what we have discussed so far, it is clear that it is quite difficult to know the direction in which the price will go after the breakout occurs. However, the developer of the Bollinger Band, John Bollinger offers three major clues. He suggests using other indicators with the Bollinger Band. He proposed using an indicator like the relative strength index. This should be combined with two volume-based indicators like the accumulation/distribution index and the intraday intensity index.
If you observe a positive divergence in which the indicators are moving in an upward direction while the price moves down or remains neutral, that is a bullish signal. For further confirmation, watch out for volume accumulation on the days of upward movement. But the price is rising while the indicators are displaying a negative divergence, watch out for a downside breakout. This is true, especially if there have been rising volume spikes on days of downward movement.
Another clue offered by Bollinger is to observe how the upper and lower bands move when they expand. It is a good hint for the direction of the breakout. Whenever there is a strong trend, there is resulting in explosive volatility that is usually high. This leads to the lower band turning downward in an upside break while the upper band turns upward in a downside breakout.
The third clue is something known as a “head fake”. It is not unusual to see the price of an asset move in a certain direction after the squeeze. It is almost like the price action is baiting traders into thinking the breakout will occur in that direction.
It then undertakes a reversal to make the real and more significant move in the opposite direction. So, traders who are too quick to make a move on the breakout end up getting caught offside. This can turn out to be very costly if they fail to use stop-losses. But the traders already anticipating the head fake will only maintain their original position and then place a trade in the direction of the reversal.
Bollinger Band Squeeze trading example (short position)
The chart below displays an example of a short trade position using the Bollinger Band squeeze.
For this example, the first step is to determine the area of the Bollinger Band squeeze. From there, plot the high and low levels of the price range. When the breakout happens to the downside, the trader can then take a short position once the next candlestick opens. Use the risk-to-reward ratio of 1:1 and 1:2 to manage the trading positions as appropriate.
Bear in mind that the price does not always get to the 1:2 profit level and this is what happens in the chart above. This is why traders need to be intentional in managing their trading positions when using the Bollinger Band squeeze trading strategy
Bollinger Band Squeeze trading example (long position)
The chart below displays an example of a long trade position using the Bollinger Band squeeze.
From the chart, it is clear that the setup happens after the squeezing of the upper and lower bands begins. It takes place close to the low end of the price. Once the upper and lower bands contract, the price action turns sideways before moving in a range.
At this point, the trader has the first signal to arrange the necessary setups. Remember to identify the high and low during the Bollinger Band squeeze. The trader then needs to wait for the expansion of the bands and the occurrence of a breakout. The strong bullish candlestick on the chart above displays the breakout. After confirming the breakout, the trader can take a long position once a new session begins after the breakout. Position the stops at the low while setting the target levels to 1:1 and 1:2 risk to reward ratios.
It may sometimes be observed that after a breakout, the price usually retests the breakout level to set up support. While it is not a bad idea to await the retest, the problem is that retests rarely happen. So, waiting for such signals can cause traders to miss out on trading opportunities.
The Bollinger Bands is one of the simplest technical indicators that can be used for trading. It also has a two-pronged function. It displays the prevailing trend along with the periods of price consolidation and breakouts. This is why it is widely used by traders when trading breakouts in the markets.
The Bollinger Band squeeze trading strategy applies to daily or even smaller timeframe charts. Like every trading strategy, the Bollinger Band squeeze also requires some practice to get the best results. While it can be used alone, it is always better to combine the Bollinger Band with other technical indicators for additional confirmation.
When using the Bollinger Band indicator, an important thing to remember is that it is not necessary to add another moving average. This is because the Bollinger Band indicator operates with the aid of the 20-period simple moving average. This moving average is not fixed as it is open to adjustments. Since no two assets will act the same way in the market, the customization of parameters that Bollinger Band offers is an added benefit.
It is worth pointing out that the Bollinger Band squeeze is not the peak of trading strategies. Like every other strategy or aspect of the trading world, it has its limits. So, traders have to be smart when using this strategy and always consider the risks before making trading decisions. It is advisable to always carry out adequate research before adopting any trading strategy. This will ensure that your capital is protected while also boosting your chances of making profits.
Also, not every trade will turn into a winning trade no matter how accurate your market predictions are. This is why you should always give yourself an exit point so that there is a way out whenever a trade does awry. Finally, you must remain disciplined because the unpredictable nature of the market means there is always a potential for losses. So, maintaining a logical perspective over an emotional one will be crucial to your success regardless of the adopted strategy.