Using Bollinger Bands with CFD Trading
Ever since John Bollinger developed the Bollinger Bands technical indicator in the 1980s, countless traders around the globe have been using it to guide their trading activities. The discussion that follows will highlight the strengths and weaknesses of this indicator in relation to CFD trading.
Remember: no technical indicator is a crystal ball. It is always a good idea to get a confirmation signal from a second indicator before entering or exiting a trade. On the other hand: using too many indicators will often result in confusion and ‘indicator paralysis’ because of conflicting signals.
There are 3 lines or ‘bands’ that together form the Bollinger Bands. The middle one is simply a moving average of the price for the past 20 periods. (This period can be adjusted according to trader preferences and market conditions). The top and bottom bands simply represent the middle band plus or minus (usually) two standard deviations. This can also be adjusted.
For readers who are not familiar with the term ‘standard deviation’ – this is an indication of the recent volatility of the price. In a highly volatile market the upper and lower bands will therefore be further away from the centre band and in a low ‘flat’ market these bands will move close to the centre band.
Below is a typical chart showing 20-period 2 standard deviation Bollinger Bands.
There are a few ways to interpret Bollinger Bands:
The outer bands
These are the outer limits based on recent price volatility levels. This simply means that when the price reaches the top band, there is a high probability that it will bounce back and start moving towards the centre band again and vice versa: if it reaches the bottom band there is a high probability of a reversal in direction back to the centre band.
In Fig 11.09(a) points A and B reflect this reality. In both instances the price turned around before breaking through the outer band and started moving in the opposite direction. These points therefore served as resistance (point A) and support (point B) levels.
This is particularly true if the centre band is virtually horizontal – indicating a market without a lot of momentum.
The centre band
Many traders ignore the slope of the centre band at their own peril. A flat centre band usually means a range bound market, while a steeply sloping band indicates a strong trend in one or the other direction.
Point D in Fig. 11.09(a) is a good example. After hitting the upper band the price did not turn around; instead it went on to form new highs. A trader who looked at the centre band would have noticed that it was sloping steeply upwards at this point – indicating a strong uptrend.
As explained earlier, when the outer bands start moving closer to the centre band, the ‘tunnel’ formed by the Bollinger Bands will narrow – as can be seen at points A and C in Fig. 11.09(a). This is a period of low volatility – which very often constitutes the ‘calm before the storm’. The longer such a period lasts, the higher the likelihood of a breakout – either to the upside or downside.