Welcome to part 1 of our Bollinger Bands Trading Strategy series!
Today we are going to explore a profitable, beginner-friendly, mean reversion style trading strategy based on the Bollinger Bands – one of the most popular technical analysis indicators used by traders across all different markets around the world.
The goal of this strategy is to use the Bollinger Bands indicator to generate reliable buy & sell signals which we can use to make informed trading decisions.
How are we going to do that?
I’m about to tell you!
But first, we need to have a solid understanding of what mean reversion actually means and what information the Bollinger Bands convey.
Most trading styles can be categorized into either mean reversion or momentum style strategies. The difference between these two categories is actually rather simple to understand.
Mean reversion strategies profit when price trades within a range without often making sustained breakouts either higher or lower. Momentum style strategies are the opposite. They profit greatly when the price continues to move overwhelmingly in one direction. Both of these kinds of strategies have their own set of advantages, disadvantages, and “best use case” scenarios.
Mean reversion strategies are extremely effective in many different markets throughout the world and across a broad range of different trading instruments – and the Bollinger Bands are an excellent technical indicator to base a mean reversion trading strategy on.
The Bollinger Bands are often used for the purpose of generating signals to determine when price is entering over-sold or over-bought areas on the chart relative to recent price. Over-bought and over-sold areas give us an idea of places on the chart where price might reverse and start moving back in the opposite direction – reverting toward the mean (average) price.
The Bollinger Bands consist of an upper and lower band which are plotted two standard deviations on either side of a 20-period simple moving average (20SMA). This 20SMA represents the average price of the last 20 candle-sticks.
When price moves a greater distance than two standard deviations away from its recent average (20SMA), it is said to be over-extended and often will find its way back to either the middle or the other side of the Bollinger Bands.
You will notice in periods of price consolidation, the Bollinger Bands will begin to narrow, and consequently, in periods of inflated volatility, the Bollinger Bands will begin to expand. This is due to the logic of the math behind statistical ranges and standard deviations – explained simply, the more price moves away from the 20SMA, the larger the standard deviations become.
When a candlestick closes in an area considered “over-sold” (below the lower band of the Bollinger Bands), and subsequently re-enters the Bollinger Bands range, this is considered a buy signal. Similarly, when a candlestick closes in an area considered “over-bought” (above the upper band of the Bollinger Bands), and then falls back into the Bollinger Bands range, this is our signal to sell.
This is the basis of our Bollinger Bands trading strategy.
Now, if you’re thinking:
“Surely not all of these “buy” and “sell” signals will result in profitable trades”
– you’re absolutely correct!
In fact, some of these “buy” and “sell” signals will result in quite substantial losses. Due to this, we need to put an additional measure in place to ensure we are only making trading decisions based on the best of the signals given to us by the Bollinger Bands indicator.
We only want to trade in the direction of the trend!
To ensure we are always trading in the same direction of the trend of price, we will only take buy signals when the 200SMA is pointing higher.
If you are using our free Bollinger Bands Strategy indicator for yourself, you’ll notice the bands are colored “green” when the 200SMA is pointing higher and the price is trending up; and red when trending down.
We also need to make sure that our losing trades are always capped and kept small when compared with our winners. To do this, we need to use a stop loss. For the purposes of this strategy, we are going to position our stop loss directly below the lowest point of the candlestick from which our buy signal has been generated, or the candlestick prior, whichever is lower.
Now that we have covered the basics of the strategy, let’s quickly summarise our rules:
Bollinger Bands Mean Reversion Strategy Rules:
- We will buy when the most recent candle-stick has closed below the lower band of the Bollinger Bands, then re-enters the Bollinger Bands range AND the 200SMA line is pointing in an upward direction.
- We will place our stop loss directly below the lowest point of the buy signal’s candlestick or the prior candlestick (whichever is lower).
- We will sell our position when the price closes above the upper band of the Bollinger Bands and then falls back into the Bollinger Bands range, or when the price hits our stop loss.
If you would like to view our backtested results from this strategy, check out our video at the following link:
To use our “Bollinger Bands Mean Reversion” Trading View Indicator for yourself, please follow this link.
Use our free indicator to experiment with selling ½ of your position when a candle-stick closes above the 20SMA middle line and the other half when given a “sell” signal and see for yourself what effect this has on your results!