How to Spot Trend Reversals With Bollinger Bands
Bollinger Bands are one of my favorite tools for trading and investing. In this article, we will learn how to use them as a framework for spotting potential trend reversals.
What are Bollinger Bands?
John Bollinger invented Bollinger Bands in 1983. At the time, he was the chief market analyst on the Financial News Network (FNN).
Bollinger bands are a simple technical tool that can tell us about the volatility of a particular asset being traded. If used the right way, they can also tell us when an asset is trending, in a range, or is more likely to reverse in price.
Importantly, Bollinger Bands are adaptive because they are constantly reacting to the price.
This makes them useful for trading and investing.
How do Bollinger Bands work?
Below we have a daily chart of gold from mid-2019 until the present day. You will notice 3 coloured lines on the chart. Below is an explanation of each of them:
- Yellow dotted line (middle): the 20-day moving average of the gold price. This is based on the daily closing price of gold.
- Green solid line (top): the yellow dotted line plus 2 standard deviations of volatility.
- Blue solid line (bottom): the yellow dotted line minus 2 standard deviations of volatility.
Together, these bands show us the relative volatility of the gold price around the 20-day moving average:
We can see on the above chart that the bands expand as the price becomes more volatile, and contract when the price gets less volatile.
This is useful information for traders because low volatility usually precedes high volatility. In other words, big price moves become more likely when the bands have been “pinching” close together for a long time.
Notice in the above chart how this happened before and after the Corona crash of March 2020. It also happened before and after gold’s major rally and subsequent top in July 2020.
Using Bollinger Bands:
“Buying low and selling high” is one of the hardest things to do in trading. This is because it is very difficult to tell what is low and what is high.
According to Bollinger’s research, about 95% of the time prices fluctuate within the upper and lower band. This percentage can increase or decrease depending on the number of standard deviations used for the upper and lower band.
Higher standard deviations will capture more of the price action.
Therefore, with Bollinger bands, we have a dynamic framework to help us determine relative highs and lows in the price of an asset:
- The price is relatively expensive when it is close to the upper band.
- The price is relatively cheap when it is close to the lower band.
Does this mean we should blindly buy an asset when it is near the bottom band and sell when it is near the top?
Absolutely not! The problem here is that the bands also move up and down with the price. So very often, this could lead to buying low and selling…lower.
With that said, Bollinger bands can still be extremely useful for confirming topping and bottoming formations for traders…
Bollinger Bands and “W bottoms”:
John Bollinger studied countless price charts in his research and found that most of the time prices form some type of W bottom pattern to mark the low point. They then reverse a downtrend to the upside. Prices only form quick V-shaped bottoms on rare occasions.
When W bottoms form on price charts, we can use Bollinger Bands to help us validate if they are true bottoming patterns.
To explain this phenomenon, let’s use the weekly DXY chart. This chart measures the price of the US dollar versus a basket of other currencies.
The above chart shows two weekly low points for the US dollar. The first low occurred outside the bottom band. This could have been a sign that the US dollar was relatively cheap versus its 20-week moving average price.
However, we do not have much information to tell us if the dollar would continue to trend down after this first low was put in. In fact, we can see that at this point, the band width was expanding.
This suggests that volatility was increasing while the price was going down. This is usually not a good sign as it implies that the price can go down more.
But what about the second low? This is different. Here, we can see that the volatility is decreasing because the bands are contracting. This tells us that the downtrend is slowing down.
We can also notice that the second low occurs closer to the middle band and further inside the lower band. This tells us that the second low is relatively higher than the first low.
It is common knowledge amongst traders that higher lows are the first sign of a downtrend reversal. But how many times have you seen a trend reverse with a lower low? This happens all the time, and often means that traders will miss out on getting in closer to the actual bottom.
This is because W bottoms can have many shapes and sizes. The second low does not always have to be higher than the first low.
By using Bollinger Bands, we can trade based on relative higher lows rather than absolute higher lows.
Below is a recent example of how this could have been used with bitcoin. Here, we used the 1-day chart for a potential long swing trade entry. We can see that the daily candle close of the second low is slightly lower than that of the first low.
Yet by using Bollinger Bands, we can see that the second low is relatively higher than the first low.
We could also have used the same logic to confirm a local W bottom for Ethereum. Notice how in this case, the second low is much lower than the first low. But again, the second low is a relative low in price according to Bollinger band theory:
We can apply the same logic to any time frame. This will depend on the trading style of the trader.
Bollinger Bands and “M” tops:
We can use Bollinger Bands in the same way when opening short positions. But instead of W-shaped bottoms, we have M-shaped tops.
According to Bollinger, tops are more complex than bottoms. This is because bottoms create a lot of fear, whereas investors often become complacent at tops. This means that tops are often a series of M patterns rather than just one. We saw this play out recently with the Bitcoin Wyckoff top.
The below chart shows how Bollinger Bands could have been used as a framework to help us identify whether we were in a Bitcoin topping phase:
Bollinger bands are a useful addition to any trading strategy because they can provide us with a framework for relative price movements. They can be used effectively in just about every trading time frame.
If you would like to learn more about Bollinger bands, I recommend reading the book written by the man himself:
Disclaimer: this is not investment advice. I am just a guy writing about trading and investment concepts on the internet.