Thursday October 21, 2010

By: Shane Wisdom, Wisdom Financial, Inc.

Introduction

The Bollinger Band was developed by John Bollinger in the 1980s to measure an overbought or oversold condition in the market.  The Bollinger Band basically consists of 3 lines: an upper band that defines resistance, a lower band that defines support, and a middle band that defines the trend.  The sensitivity of the Bollinger Band is defined by the period or number of days that the indicator references.  For example, a 10 period Bollinger Band is going to be much more reactive to price than a 100 period Bollinger Band.

Trend Following vs Counter Trend

Many traders use Bollinger Bands to find turning points in the market, buying when price hits the lower band and selling when price hits the upper band.   In range bound markets, this will typically work well as price travels between the bands and may give traders several opportunities to pick tops and bottoms. 

However, as markets start to break out of the trading range and move into a trending environment price will often "walk the band" as momentum picks up and a directional trade ensues.  Traders that are caught in that mode of trying to pick tops and bottoms are faced with a difficult series of losing trades or even worse an ever mounting loss as price moves further and further away from the old trading range.

The Set Up

In my experience, I've found Bollinger Bands to be a better indicator for "Trend Following", as opposed to "Counter Trend" trading.  Instead of using Bollinger Bands to pick tops and bottoms, I'd prefer to use the breakout of a Bollinger Band to tell us when new trends are actually beginning.  With this strategy we'll never pick a top or bottom like we might with the counter trend method, however our potential winning trades should be substantially larger and last much longer in duration. 

With this set up, we're looking for price to close outside of the upper or lower band, esentially a "breakout" of the current trading range as defined by the Bollinger Band.  When this happens, we want to take a trade in the direction of the breakout as a new trend appears to be starting. 

Each trade that we enter has a predetermined amount of risk measured by the close of the market price on the day of the breakout to the middle Bollinger Band, or moving average.  This value should be considered for money management purposes and determining how many contracts you can buy or sell in your account.  In volatile market environments, trade risk will be higher suggesting you should trade conservatively.  The middle Bollinger Band acts as our trailing stop and if price closes below the middle band we exit the trade.   

Conclusion

While Bollinger Bands serve several purposes, I've found them to perform best when used for low frequency Trend Following.  The Bollinger Band strategy will adjust with market volatility, provide specific entry and exit signals, and uses a trailing stop that will move with the market and lock in profits along the way.  If applied correctly, this strategy can help disciplined traders capitalize on long term trends in markets around the globe.

By Shane Wisdom

Wisdom Financial, Inc.

http://www.wisdomfinancialinc.com/

Shane Wisdom is President of Wisdom Financial, Inc. an independent introducing brokerage firm located in Newport Beach, CA.  Shane specializes in working with trend following systems and trend following traders around the globe.  Mr. Wisdom can be reached directly at:

Toll Free:800.854.6354  Direct: 949.933.1079 Email: Shane@wisdomfinancialinc.com