DAYTRADER’S MENTOR

January, 2000 - Issue 3-1

BOLLINGER BANDS AS AN ENTRY TECHNIQUE

Standard deviation bands or Bollinger Bands, named after John Bollinger who has popular-
ized them, are bands equidistant above and below a moving average of price. The distance
of the bands from the selected moving average is based on the standard deviation one
desires. Most charting packages support the plotting of Bollinger Bands and allow the
selection of:

1. The type and length of the moving average around which the Bollinger
Bands are plotted, and
2. The number of standard deviations to calculate from the above moving
average.

We prefer a 20-period, simple moving average and 2.0 standard deviation which will
contain about 95% of price action. To use Bollinger Bands as an entry technique, we wait
for price to penetrate one of the bands. If the upper band is penetrated, we will want to
trade the long side. If the lower band is penetrated, we will trade the short side. We want a
band to be penetrated preferably with momentum. If the ADX concurrently moves from
below 10 or 16 to above 16, we have a potential trade. When price retraces to the moving
average, we will want to enter the trade: long, if the upper band was penetrated and short, if
the lower band was penetrated.

Chart A

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Realize this should not be considered a stand-alone technique; this is an entry trigger
only. Other, longer-term analysis must be done to ensure one is not trading into the maw of
a black hole.

On Chart A, the Treasure Bonds daily bar chart, the daily moving average is active
(meaning price momentum down has pushed the daily ADX above the 30 threshold). By
looking at the daily Treasury Bond chart, one can see that the daily 20-period exponential
moving average has reversed price at every recent attempt to move higher. Down Arrow 3
is the reversal from the proximity of the daily 20-period exponential moving average and
corresponds with Down Arrow 3 on the following intraday charts (Charts 1, 2 and 3).

Chart 1

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There are other considerations as well. One of our guiding tenets is that what works in
one time frame, should also work in other time frames; if an approach, technique, or system
is to have robust validity in the real world of trading, it should, on average, work in all time
frames. What happens when price moves into the upper 1-minute Bollinger Band and the 3-
minute Bollinger Band simultaneously? Does price reverse and move to the 1-minute aver-
age or the 3-minute average?

The answer to these questions lies in momentum and support/resistance levels. If price
is trending strongly on the 1-minute chart, then price will probably be supported by the 1-
minute, 20-period exponential moving average, probably three times, and will then be
supported by the 3-minute, 20-period exponential moving average about three times.

Chart 2

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This is the ideal case in a strongly moving market. Successive longer-term averages
will support price as the trend matures. Should short-term momentum have a spurt that
forces the 1-minute ADX very high, that moving average or another, may be reactivated
and the 1-minute average will again support price. As an example, three intraday charts
are presented.

We have included the same 1-minute chart with the 1-minute Bollinger Bands only
(Chart 1), another chart with the 1-minute and 3-minute Bollinger Bands (Chart 2) and
finally, a chart with the 1-minute and 5-minute Bollinger Bands (Chart 3). We have done
this in order to demonstrate how one can go wrong by looking at only one time frame
and how multiple time frames can help this technique.

Chart 3

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Chart 1 is a 1-minute chart with the 1-minute, 20-period exponential moving

average (red) and a 2.0 standard deviation Bollinger Band around a 20-period, simple
moving average (red).

Chart 2 is a 1-minute chart with the 1-minute, 20-period exponential moving

average (red) and a 2.0 standard deviation Bollinger Band around a 20-period, simple
moving average (red) and a 3-minute, 20-period exponential moving average (blue) with
a 3-minute, 2.0 standard deviation Bollinger Band around a 20-period, simple moving
average (blue).

Chart 3 is a 1-minute chart with the 1-minute, 20-period exponential moving

average (red) and a 2.0 standard deviation Bollinger Band around a 20-period, simple
moving average (red) and a 5-minute, 20-period exponential moving average (black)
with 5-minute, 2.0 standard deviation Bollinger Bands around a 20-period simple mov-
ing average (black).

Charts 1 through 3 are all 1-minute Treasure Bond charts from January 20, 2000.
This technique however works with all tradeable securities, including stocks. The fol-
lowing description and price action analysis applies to all charts.

At Down Arrow 1, price penetrates the 1-minute Bollinger Band and one can
reasonably assume that price will move back down to support at the 1-minute average.

Instead, price moves down toward the 3-minute moving average because the 3-
minute Bollinger Band was also penetrated. The same pattern occurs at Down Arrow 2
where the 1-minute and 3-minute Bollinger Bands have both been penetrated and price
moves to the 3-minute average.

The reason the 1-minute average cannot support price is because not enough
momentum to the upside has been generated. This is not the case on the move up after
11:00 Central. Price is trending as verified by the ADX moving well above the 30
threshold. The 1-minute average supports price very well through here until Down
Arrow 3.

Because of the tendency for the daily average to reverse price because it has been
“activated” by an ADX of 30 or greater, we must keep a tight stop. This is especially
true after the third push up which is where price often reverses. These three pushes up
are indicated by large up arrows labeled A, B and C.

At Up Arrow C, we would bring our protective stop up to the 89.85 level and
higher once price made its 12:20 Central push up.

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At Down Arrow 3, price reverses and closely follows the 1-minute Bollinger Bands
down. At Down Arrow 4, price encounters the 3-minute Bollinger Bands and price moves
higher. If one did not know that price had penetrated the 3-minute Bollinger Bands, one
would assume that price would reverse at the 1-minute moving average. This is not the case
here and price moves higher to retrace to the 3-minute moving average.

Another mistaken interpretation of the Up Arrow at 4 is that price is retracing from the
5-minute Bollinger Bands to the 5-minute moving average. In fact, price is retracing from the
daily moving average and moving back to the lower daily Bollinger Band. A long at Up
Arrow 4 would be proven wrong very quickly. If price is not interacting with the Bollinger
Bands in the manner you anticipated, look at the longer-term interactions.

To the casual observer, the move up into the 1-minute Bollinger Bands at Down Arrow 5
could be taken as a price reversal rather than as a retracement to the 3-minute moving aver-
age. One could mistakenly buy the retracement to the 1-minute average here and immediately
take a big hit.

The astute trader would recognize the movement of price up to Down Arrow 5 for what
it was: a retracement of price from a penetrated lower 3-minute Bollinger Band back to the 3-
period exponential moving average. Given the reversal off of the daily moving average, this
would be an excellent shorting point. Price did in fact immediately move over half a point
lower.

Because of this interaction of price with Bollinger Bands and the respective 20-period
exponential moving averages, we plot multiple Bollinger Bands and moving averages in one
price chart. On a 1-minute chart, we plot the 1, 3 and 5-minute Bollinger Bands and their
respective moving averages. On a 5-minute chart, we plot the 5, 15, 30 and 60 minute
Bollinger Bands and their respective moving averages. The longer-term averages take prece-
dence.

Bollinger Bands, when used in conjunction with other analysis, can be used as an effec-
tive entry trigger. The Bollinger Bands validate direction of the trade and give a specific entry
point. The usefulness and necessity of looking at these bands in a number of time frames
cannot be overstated.

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