Most traders are familiar with the Bollinger Bands® as a trading tool to see when prices are relatively overbought or oversold. The Bollinger Bands® are created by drawing a line, two standard deviations from a moving average. The theory behind this is that price is elastic. It will often stretch away from the average to extremes and then snap back to that average. Deviation of price tells us how far prices should move away from that average and is a function of volatility. Two standard deviations should include roughly 96% of all closings. If we do close outside of that line, we are unlikely to continue to do so without retracing back to the average first.
This is extremely helpful when price is also at a supply or demand zone for an entry or exit to a trade. If price is outside the band while entering a supply or demand zone, then the band increases our confidence and probability that the trade will work.
Were you aware that the Bollinger Bands® can also be used to judge the strength or weakness of a trend? In a strong bullish trend, price will typically bounce between the upper band and the midpoint, the 20 period exponential moving average. We often use that average as a target when shorting a counter trend move from supply in a bullish trend. Those of you who have attended the Professional Trader Course are aware of the All Star entry that details this exact trade.
If you notice that prices are simply correcting to the 20EMA in a bullish trend instead of moving all the way to the lower band, then the trend is still powerful and the following impulses should carry price to new highs.
However, once you see the correction pierce that 20EMA and touch the bottom band, the trend has weakened and you may need to be stricter with the long trades you take as the trend has weakened. Look to exit at the supply levels rather than letting profits run as price is less likely to move to new highs. The failure of price to reach the upper bands could also signal weakness in the trend as evidenced in the Nifty before the 2010-2011 bear market began.
The same strategy works for the bearish markets. When price is bouncing between the bottom band and the midpoint of the 20EMA, then price is bearish and short positions should be initiated.
When we were looking for signals that the 2008 bear market was over, there were several. In addition to higher highs and higher lows being created, the touch of the upper Bollinger Band® on the weekly chart of the Nifty showed the bear trend weakened and may have reversed.
Remember, using the bands in this manner is a bit lagging. The trends will usually change before you get a signal but it can help when trying to determine the probable direction and strength of the trend. So use your analysis skills to enter the best trades at supply and demand zones, but keep in mind the trend that you are trading in. This will minimize potential losses and more importantly, increase your chances for success in the markets.