4 RULES FOR USING THE MOST USEFUL TECHNICAL INDICATOR, DOUBLE BOLLINGER BANDS
In her book, The Little Book of Currency Trading, forex analyst Kathy Lien writes:
Of the hundreds of technical indicators out there, the Double Bollinger Bands are hands down my favorite…they provide a wealth of actionable information. They tell me whether a currency pair is in a trend or range, the direction of the trend, and when the trend has exhausted. More importantly, Bollinger Bands also identify entry points and proper places to put a stop.
While Ms. Lien refers above to currency trading, her words apply to any other major financial asset to which technical analysis is applied. Here’s a short summary of how to use Double Bollinger Bands (DBBs). This short version is for those who just need a quick review of them. Those needing more background and a full explanation of DBBs should refer to my book, The Sensible Guide To Forex, pages 229-37.
Why Every Serious Investor Or Trader Should Know DBBs
Most experienced traders and investors use a combination of both fundamental and technical analysis. The mix depends greatly on the both personal preferences, and especially on their preferred time frames.
LONG TERM INVESTORS
They need to consider fundamentals, much more than short term traders, because most fundamental factors take time, sometimes months or many years, to fully exert their influence. For example, the long term fundamentals for Japanese or US bonds may be grim (PIMCO recently dumped their entire portfolio of US bond holdings), however the prices of these assets have yet to reflect the fading likelihood that current investors buying these will actually get the returns they anticipate, as inflation erodes both their principle and income stream. Thus long term investors select their investments more on fundamentals, and then use some technical factors to choose entry and exit points, so DBBs are relevant for them as well, and they should be familiar with the following rules for using them.
SHORT TERM TRADERS
Those traders who plan to enter and exit within less than one day or just a few days, need to be much more focused on technical indicators shown on charts. While certain kinds of fundamental data like news events can have a strong short term affect on price, short term trends are mostly moved by market sentiment and resulting money flows in and out of an asset from large institutions and short term traders. The only way short term traders can gauge how these forces are likely influence short term price movements over the coming minutes, hours, or days is via technical indicators. Thus it behooves the short term traders to be very familiar with DBBs, and review the rules of their use. For those who need more background to understand the brief presentation of the below rules, see the videos referenced at the end of this article. We’ll be referring to the below weekly chart of the S&P 500 that runs from the week of July 2008 – April 3 2011, though the indicator should work on a chart in any time frame for any asset.
CHART 1: S&P 500 WEEKLY CHART COURTESYOF ANYOPTION.COM July 18 2008 – April 3, 2011
The 4 Rules For Using Double Bollinger Bands
RULE 1: GO SHORT WHEN PRICE IS IN OR BELOW THE DOUBLE BB SELL ZONE (BOUNDED BY THE LOWER RED AND YELLOW BOLLINGER BANDS)
As long as price remains within or below the lower 2 BBs, the downward momentum is strong enough so that there is a high probability that the trend will continue. This is the time to enter new short positions. Exit and take profits when price moves above this zone. For example, looking at the SP 500 index weekly chart, if we zoom in on Q3 of 2008 shown below, from the week of September 7th (down arrow) until the week of December 14th (up arrow), the odds favored maintaining short positions for those trading off weekly charts.
CHART 2: S&P 500 WEEKLY CHART week of Sept. 7th – Dec. 14th
04 apr 06 1353
Because the downtrend needs strong momentum to enter the buy or sell zones, Double Bollinger Bands are distinctly lagging indicators and thus not suited for catching less sustained though perfectly tradable trends. For example, if you would have solely relied on DBBs during the Greek stage of the EU debt crisis that occurred in the spring of 2010, you would not have gone short the index until the trend was mostly finished. Note the chart below.
CHART 3: S&P 500 WEEKLY CHART Week of April 25 – August 1
So as good as DBBs are, like any other indicator they need to be used in combination with other technical and fundamental evidence.
RULE 2: GO LONG WHEN PRICE IS IN OR ABOVE THE DOUBLE BB BUY ZONE (BOUNDED BY THE UPPER RED AND YELLOW BOLLINGER BANDS)
As long as price remains within or above the lower 2 BBs, the upward momentum is strong enough so that there is a high probability that the trend will continue higher. This is the time to enter new long positions. Exit and take profits when price moves below this zone. For example, looking at the SP 500 index weekly chart below, we zoom in on July 27 – Sept. 27 highlighted by the red arrows the odds favored maintaining long positions for those trading off weekly charts. If look at the chart above for the period of July 2008 – Mid March 2011, it’s clear that this indicator would have kept you in for most of the multi-year uptrend and gotten you out before most of the major selloffs played out.
CHART 4: S&P 500 WEEKLY CHART Week of July 27 2009 – Sept. 27 2009
RULE 3: DON’T TRADE BASED ON DBBs WHEN PRICE IS BETWEEN THE BUY AND SELL ZONES When price is in the middle zone of the 1 standard deviation Bollinger Bands (in red), the trend isn’t strong enough to trust, so don’t trade it, unless you have enough other fundamental evidence or signals from your other technical indicators that suggest the trend will continue. See Chart 5 below for examples when this did and didn’t work during the EU Crisis (Greek Stage) of 2010.
Chart 5: S&P 500 WEEKLY CHART – GREEK STAGE OF EU DEBT CRISIS 2010
Red Arrows Highlighting weekly candles of April 25 2010, May 16 2010, Sept. 12 2010
For example, in late April 2010, according to this Rule 3 I should not have been short until the week of May 16, highlighted by the left-most up arrow. However, there was a growing chance that the EU might not bail out Greece in time to avoid a market collapse, so I didn’t wait to start taking at least some short positions – the fundamentals (and other technical signals I was watching) were enough to justify ignoring Rule 3. My fundamental thesis: If the collapse of just 1 major bank (Lehman brothers) crashed markets in September of 2008, imagine what a national default (and wave of defaults that would follow as no one would lend to the other weak EU economies could do. So that was a classic case of when to ignore rule 3, and of the need to find that balance between using too little evidence to see the full picture, and using so much that it paralyses you and prevents you from taking action. In the spring of 2010 DDBs were just not enough. However, Rule 3 would have worked well in keeping you out of the choppy range bound action into the spring and early summer of 2010, highlighted by the two red up arrows in Chart 5. It’s harder to trade profitably when there is no clear trend.
RULE 4: MINIMIZE RISK BY WAITING UNTIL PRICE RETRACES TO THE CHEAPER END OF THE BUY OR SELL ZONE, OR TAKE PARTIAL POSITIONS
This rule attempts to reduce the risk of buying at the top or selling at the bottom that comes when chasing a strong trend, while minimizing the risk that instead of catching a bargain, you catch a ‘falling knife.’ This rule is not easy to implement. Your success depends on how well you read the other technical and fundamental evidence, and how well you are able to understand if you’re catching a bargain or a falling knife.
THUS THE KEY QUALIFICATION TO RULE 4: THERE ARE NO MAJOR CONTRADICTIONS FROM OTHER TECHNICAL INDICATORS OR FUNDAMENTAL DATA THAT SUGGEST THE TREND IS IN FACT EXHAUSTED.
If there are, stand aside, don’t trade. For example, look at Chart 6 below.
Chart 6: S&P 500 WEEKLY CHART
The rule worked well if you bought at the cheap end of the buy zone during the week of Sept. 27 2009 (first down red arrow), there you caught a bargain. However if you bought at the close of the week of April 25, 2010, you caught a falling knife, as a threatened Greek default set off a sharp 4 week pullback. The key was to recognize that the fundamentals were so bad that they outweighed the suggested bargain of Rule 4. What would have saved you? In addition to reasonable stop losses (which we ALWAYS USE, RIGHT?), rule 4 also suggests taking partial positions when entering strong trends, like 1/3rd of your total planned position if you can’t wait for the retracement to the cheaper end of your buy or sell zone, another 1/3rd if/when you get the retracement, and another 1/3rd when if you get a bounce back into the buy or sell zone.
CONCLUSION AND SUMMARY
Double Bollinger Bands are incredibly useful, but like any technical indicator, must be used in combination with other evidence, the precise nature of which depends on your style of trading and timeframe. Here’s a brief summary of the 4 rules for using DBBs.
RULE 1: GO SHORT WHEN PRICE IS IN OR BELOW THE DOUBLE BB SELL ZONE ( BOUNDED BY THE LOWER RED AND YELLOW BOLLINGER BANDS)
RULE 2: GO LONG WHEN PRICE IS IN OR ABOVE THE DOUBLE BB BUY ZONE ( BOUNDED BY THE UPPER RED AND YELLOW BOLLINGER BANDS)
RULE 3: DON’T TRADE BASED ON DBBs WHEN PRICE IS BETWEEN THE BUY AND SELL ZONES
RULE 4: MINIMIZE RISK BY WAITING UNTIL PRICE RETRACES TO THE CHEAPER END OF THE BUY OR SELL ZONE, OR TAKE PARTIAL POSITIONS.
Qualification: do not attempt ‘bargain hunting’ if there is significant evidence that the trend is not merely testing support but in fact reversing. If evidence suggests a reversal may be forming, then avoid the trade, or take only partial positions until the trend resumes, and use stop losses to minimize damage if in fact the trend you’re playing breaks down.
A final note: If you prefer to trade strong trends, consider trading them with binary options. For pure trend traders they can be an ideal complement to your trading, because they simplify much of the risk management decisions that turn winning trades into losers. All you have to do is predict the direction of the trend in your preferred time frame, and even if the trend only moves fractionally in your direction, your profit is usually about 70%, even if you were only trading on an hourly basis.
To see if binary options are right for you, see Chapter 11, page 316, of The Sensible Guide To Forex: Safer, Smarter Ways To Survive and Prosper From The Start. It’s the first forex book to take an in depth, objective look at this new and, if used intelligently, highly useful tool for trading currencies and other types of assets.
DISCLAIMER/DISCLOSURE: THE ABOVE IS FOR INSTRUCTIONAL PURPOSES ONLY. RESPONSIBILITY FOR APPLICATION OF THE ABOVE LIES SOLELY WITH THE READER.