How To Use Bollinger Bands
Bollinger Bands are one of the most useful trading studies out there, as they can be used in a multitude of ways. You’ve already seen how we use Bollinger Bands to conduct squeeze trades, but what about using them for another entry method? On heavily trending commodities and even some stocks (for example steel, oil, gold, silver, etc.) Bollinger bands can be used as an entry method once a trend is identified. You’ve probably heard how the best time to enter a heavily trending market is on pullbacks right? This is because the stock will come at a discounted price, plus since your entry point is on a retracement, you earn bonus points because if your stop loss if properly set it will get you out of the trade should it turn out that this retracement is actually a trend change. Entering positions on retracements avoids early stop loss activation, where the stock is still trending upwards but your stop is hit because it thought that the natural retracement in price was actually a trend change.
Below we see a weekly chart of GLD with Bollinger bands applied as well as 2 trend lines I have provided.
Early on, we would have easily identified the bearish trend on GLD by connecting the peaks and drawing Trend line 1. But when would be a good time to enter the market and profit from the bearish trend? Some traders like to use Bollinger Bands to fade market movement, and enter opposite of market direction when price action hits extreme levels, such as the lower or upper band. This method is nothing but an exercise in futility. Why would you fight an establish trend? All you are doing is expending great effort to make minimal gains while reducing your chances of success due to going against the established trend.
Instead of fading upper and lower band price levels, let’s look at a much better way to trade GLD using the bands.
The obviously smart thing to do here, would be to go with the trend not against it. We can use the Bollinger Bands to buy or sell on retracements, and enter the market short or long when price is most advantageous for us. We have already identified a bearish trend, so now we wait for the price action to touch the lower band, and make its way back to the middle band. This is called reverting to the mean. All price charts go through a series of testing lower or upper bands, but sooner or later they must revert back to the mean before continuing their trend. In a bearish trend (bullish trend rules are reversed) whenever price action reverts to the mean, and fails to establish a higher high than the peak that came before, we can conclude that most likely the established trend will continue, therefore we can use this opportunity to enter into a trade. Using this method we would short the market at points 1,2,3,4,5. The peaks that come after points 2 and points 5 are clearly breaking above the high of the previous peak, and therefore we do not short these reversions to the mean because our probability of success is decreased.
Sometime later, at point 6, we can see a trend change occur when price action blows past the middle band, as well as the top band. Connecting the 2 newly formed peaks we see a bullish trend established in GLD, illustrated by trend line 2. When this happens we change our entry method, and now we are waiting for a reversion to the mean in order to enter the market long. This reversion happens at point 7, we watch price action break slightly below the middle band and quickly start to shoot back up, we enter the trade long at this point in order to capitalize on the newly established trend.