The Ultimate Trade Setup using Bollinger Bands

Markets move between low volatility trading range moves to high Volatility trend moves. One of the best ways to see this taking place is with the Bollinger Bands. When a market makes a extremely narrow range move. The Bollinger Bands will noticably narrow together.

When the bands narrow down it shows an extremely low volatiltiy market. A low volatility market forecasts - a high volatility trend move Is more than likely - just around the corner.

This is a big trading setup and a money making opportunity is at hand.

The Bands narrowing together does not forecast the direction that the breakout will be but often times it is fairly clear from classic technical analysis which way the odds favor the breakout to be.

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WHEAT - A NARROW RANGE BASE
At the beginning of this chart from 3/20/03 to 5/06/03
Wheat made a narrow range base pattern
The Bollinger Bands narrowed down
There was no doubt that a low volatility move was happening
This put us on alert that this was a Million Dollar trade setup
A possible trading opportunity was at hand
Wheat exploded to the upside from there

THE ENTRY SIGNAL
The parabolic stop indicator
Is a great way to make sure you are on board for the big move
And a good indicator to use as a stop
Sometimes it takes a couple of trys to get aboard the big move
The parabolic is a stop and reverse trading system
The parabolic will work excellent as an entry signal
Then use the parabolic stop and reverse signal
To change positions in the market if need be

So you use the parabolic to:
#1 - Enter the market
#2 - As a stop if wrong on the entry signal
#3 - As a new entry point to go with the market the other direction if need be

The parabolic indicator is just one idea for an entry signal
You can use whatever entry signal works for you
When you see a low volatility market

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The reason it may take a couple trys
To get in the market on the right side of the big trend move
Is because the market may make a false breakout
For example the market may make a base and be ready to make a strong rally
But first may make a strong move below the base
This is called a false breakout or head fake
Then the real move may begin and the market will rally from there

The false breakout can be in either direction
And sometimes there may be a couple of false moves

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FROM JOHN BOLLINGER - ON BOLLINGER BANDS
www.bollingerbands.com

Years ago the late Bruce Babcock of Commodity Traders Consumers Review interviewed me for that publication. After the interview we chatted for a while--the interviewing gradually reversed--and it came out that his favorite commodity trading approach was the volatility breakout. I could hardly believe my ears. Here is the fellow who had examined more trading systems--and done so rigorously--than anyone with the possible exception of John Hill of Futures Truth and he was saying that his approach of choice to trading was the volatility-breakout system? The very approach that I thought best for trading after a lot of investigation?

Perhaps the most elegant direct application of Bollinger Bands is a volatility breakout system. These systems have been around a long time and exist in many varieties and forms. The earliest breakout systems used simple averages of the highs and lows, often shifted up or down a bit. As time went on average true range was frequently a factor.

There is no real way of knowing when volatility, as we use it now, was incorporated as a factor, but one would surmise that one day someone noticed that breakout signals worked better when the averages, bands, envelopes, etc., were closer together and the volatility breakout system was born. (Certainly the risk-reward parameters are better aligned when the bands are narrow, a major factor in any system.)

Our version of the venerable volatility breakout system utilizes BandWidth to set the precondition and then takes a position when a breakout occurs. There are two choices for a stop/exit for this approach. First, Welles Wilder's Parabolic3, a simple, but elegant, concept. In the case of a stop for a buy signal, the initial stop is set just below the range of the breakout formation and then incremented upward each day the trade is open. Just the opposite is true for a sell. For those willing to pursue larger profits than those afforded by the relatively conservative Parabolic approach, a tag of the opposite band is an excellent exit signal. This allows for corrections along the way and results in longer trades. So, in a buy use a tag of the lower band as an exit and in a sell use a tag of the upper band as an exit.

The major problem with successfully implementing Method I is something called a head fake--discussed in the prior chapter. The term came from hockey, but it is familiar in many other arenas as well. The idea is a player with the puck skates up the ice toward an opponent. As he skates he turns his head in preparation to pass the defender; as soon as the defenseman commits, he turns his body the other way and safely snaps his shot. Coming out of a Squeeze, stocks often do the same; they'll first feint in the wrong direction and then make the real move. Typically what you'll see is a Squeeze, followed by a band tag, followed in turn by the real move. Most often this will occur within the bands and you won't get a breakout signal until after the real move is under way. However, if the parameters for the bands have been tightened, as so many who use this approach do, you may find yourself with the occasional small whipsaw before the real trade appears.

Some stocks, indices, etc are more prone to head fakes than others. Take a look at past Squeezes for the item you are considering and see if they involved head fakes. Once a faker.

For those who are willing to take a non-mechanical approach trading head fakes, the easiest strategy is to wait until a Squeeze occurs--the precondition is set--then look for the first move away from the trading range. Trade half a position the first strong day in the opposite direction of the head fake, adding to the position when the breakout occurs and using a parabolic or opposite band tag stop to keep from being hurt.

Where head fakes aren't a problem, or the band parameters aren't set tight enough for those that do occur to be a problem, you can trade Method I straight up. Just wait for a Squeeze and go with the first breakout.

Volume indicators can really add value. In the phase before the head fake look for a volume indicator such as Intraday Intensity or Accumulation Distribution to give a hint regarding the ultimate resolution. MFI is another indicator that can be useful to improve success and confidence. These are all volume indicators and are taken up in Part IV.

The parameters for a volatility breakout system based on The Squeeze can be the standard parameters: 20-day average and +/- two standard deviation bands. This is true because in this phase of activity the bands are quite close together and thus the triggers are very close by. However, some short-term traders may want to shorten the average a bit, say to 15 periods and tighten the bands a bit, say to 1.5 standard deviations.

There is one other parameter that can be set, the look-back period for the Squeeze. The longer you set the look-back period--recall that the default is six months--the greater the compression you'll achieve and the more explosive the set ups will be. However, there will be fewer of them. There is always a price to pay it seems.