Trend Following and Mean Reversion Strategies With Bollinger Bands

Bollinger Bands are a very useful indicator developed by John Bollinger based on a moving average and standard deviations. There are four parts to Bollinger Bands:

1. Moving Average: By default, a 20-period simple moving average is used.
2. Standard Deviations: A measure of the volatility of the price series.
3. Upper Band: The upper band is usually 2 standard deviations (calculated from 20-periods of closing data) above the moving average.
4. Lower Band: The lower band is usually 2 standard deviations below the moving average.

At 2 standard deviations, Bollinger Bands should contain 85% of the movement of the instrument being measured. The higher the number of standard deviations used will make it so that even more of the price data is contained in the bands. Conversely the smaller the number of standard deviations used will result in less price data in the bands.

Knowing that you can see how these can be used in several ways, a few of which we will mention here. For stock trading the two most used strategies using bands are breakout and mean reversion trading.

Breakout-Since roughly 85% of a securities price action is contained in the bands many traders see a movement outside of the bands as a significant sign that something is happening whether it be an earnings announcement, buyout, or just a big move in the sector or market. So if the stock hasn't been moving too much and then breaks up above the upper band they would consider buying it (You would do the opposite if it broke down below the lower band). A simple breakout strategy would be to buy (or short) when a security closes above (or below) the upper (or lower) band and exit when it closed below (or above) its moving average.

Mean Reversion-Since approximately 85% of a stocks price action is contained in a 2 standard deviation Bollinger Band another way to use them is to sell or sell short when a stock gets to the upper band and buy when it gets to the lower band.

As you can tell there are several ways to use Bollinger Bands. For instance you could take the mean reversion strategy and overlay a Bear Call Spread/Bull Put Spread strategy over it by selling a slightly out of the money call and buying the next strike up when the stock pierces the upper band and doing the opposite (sell the slightly out of the money put and buy the next strike down) when it pierces the lower band. This is but one of many variations of trading strategies where Bollinger Bands can come in useful.

About the Author

Dave is a contributing writer to TheMacroTrader.com a newsletter that uses fundamentals and technicals to trade multiple asset classes searching for the best risk-to-reward opportunities across the globe. TheMacroTrader.com

Author Profile: dctag1

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