Technical Classroom: How to trade volatility breakout with bollinger band

The purpose of Bollinger Bands is to provide a relative definition of high and low prices of a market. By definition, prices are high at the upper band and low at the lower band.

Construction of Bollinger Band (BB)

1) Components of Bollinger Band (BB)

There are three components to the Bollinger Band indicator:

• Moving Average: By default, a 20-period simple moving average (20 SMA) is used.
• Upper Band: The upper band is usually 2 standard deviations (calculated from 20-periods of closing data) above the moving average.
• Lower Band: The lower band is usually 2 standard deviations below the moving average

2) Calculations

Underlying calculations of BB are quite simple, it is based on moving average & standard deviation.

Feature & Importance of Bollinger Band (BB)

• The indicator forms a channel around the price movements of an asset. The channels are based on standard deviations and the moving average.
• Whenever price manages to close above upper band, it is called as positive volatility breakout.
• A negative close below lower Bollinger band gives volatility breakout on the downside.
• The markets move from a period of high volatility to low volatility (and vice versa). Volatility is a mean reverting parameter. So the volatility band alternates between contraction and expansion
• When the Bollinger Bands is contracting it tells that the market is in a low volatility environment. The “Bollinger Squeeze” is termed when the bands squeeze together, it usually means that a breakout is getting ready to happen.

There are multiple uses for Bollinger Bands like -

• Bollinger bands can help establish a trend's direction
• Bollinger Band can spot potential reversals
• Bollinger Band can monitor volatility.
• Bollinger Band (BB) can be used to understand overbought and oversold trade signals

Technical indicators anything from a RSI to candlestick patterns can be used with BB to help establish the trend direction. The greater the number of positive indications is for a trade, the greater the chances for success.

Trading Technique:

Intraday trading using BB & EMA (Timeframe 5 minutes)

Buying

1. Price should be trading above EMA (89, HIGH).
2. Prices should close above BB upper band.
3. Keep Trail stop loss to 20 SMA.

Selling

1. Price should be trading below EMA (89, LOW).
2. Prices should close below BB lower band.
3. Trail stop loss to 20 SMA.

Traders should use the BB breakouts in conjunction with other technical indicators to maximize their odds of success.

(The author is Head - Technical & Derivative Research at Narnolia Financial Advisors)

Disclaimer: The views and investment tips expressed by investment experts on moneycontrol.com are his own, and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.