Bollinger band squeeze trading strategy
The Bollinger band squeeze trading strategy is a type of swing trading strategy that takes advantage of impending expansions in the Bollinger Bands.
The swing trading strategy uses the contraction and the expansion in the Bollinger Bands and positions the trader ahead of a volatile move in the security or the instrument to which it is applied.
The Bollinger band squeeze trading strategy is very simple and as the name suggests, it makes use of just the Bollinger Bands. However, traders can also complement this trading system by adding additional validation indicators such as oscillators to gauge the momentum in the security.
The Bollinger band squeeze trading strategy falls under the breakout trading strategy. As a result, the trades that are taken based off the signals from this strategy is for the short term. The strategy can be applied to either the daily or the H4 chart time frame.
In some cases, traders also use this strategy on the higher time frames such as the weekly charts. It is up to the trader to see which time frame works best. There is no limitation for using the Bollinger band trading strategy on smaller time frames as well.
There is certainly no proven theory that states that the Bollinger band squeeze trading strategy does not work on the smaller time frames.
However, it is best for the trader to experiment with smaller time frames first before applying this strategy in the real markets.
In this article, we explain how the Bollinger band squeeze trading strategy works and how you can use this method to trade breakouts in the market. One of the things to bear in mind is that we make use of the 4-hour or the daily chart time frame.
The longer time frame you use, the less signals this system generates. Therefore, the H4 or the daily chart time frame is ideally suited to trade with this strategy in the medium term horizon.
How does the Bollinger Band work?
Before outlining how the Bollinger band squeeze trading strategy works, let’s first refresh our knowledge about the Bollinger Bands.
The Bollinger bands is a technical indicator that is applied to the price chart. It is also known as volatility bands. The indicator, as the name suggests is used to identify rising and falling volatility in the markets.
When the volatility rises, the security tends to rise or fall sharply. When volatility falls, the price of the security tends to move in a sideways range.
The Bollinger Bands indicator was designed by John Bollinger and was presented as a complete indicator that can represent trend as well as volatility. The bands are visually recognizable with the three lines that move around price.
The indicator is based on the 20 period simple moving average. Following this, the outer bands, known as the upper and the lower bands are set to two standard deviations away from the 20-period simple moving average.
An example of the Bollinger band with the standard setting of 20,2 is shown in the chart below. Due to its popularity, the Bollinger band is one of the default indicators that you will find with almost any trading platform.
Figure 1: Bollinger Bands indicator with 20, 2 settings
Depending on the rise or the fall in volatility in price, the outer bands start to expand and contract.
This can be seen clearly in Figure 1. The periods where the Bollinger bands contract in width is often seen by price trading in a tight range. However, once the bands start to expand in width, you can see how price moves sharply across the board.
When the Bollinger Bands contract, it represents falling volatility and when the bands expand, they represent rising volatility. Typically, breakouts in price happen during the expansion of the bands which typically follows a period of low volatility.
When the trend is strong, you can often find that price trades close to the outer bands. This indicates strong momentum and volatility.
Besides using the Bollinger Bands, you can also make use of the momentum oscillators in order to gauge the rising and falling momentum. When momentum and volatility validate price, you can expect to see strong moves in the markets.
There are many different strategies that one can employ using the Bollinger bands. Some of them include the Bollinger band squeeze strategy and walking the bands. In this article, we will focus on the squeeze strategy.
What is a Bollinger band squeeze?
The Bollinger band squeeze is the name given when the outer bands of the Bollinger Bands contract. The name comes because when the contraction happens, or the width of the outer bands starts to narrow, you can see price being squeezed.
In the next chart below, we have identified areas where there is a Bollinger band squeeze and a contraction. It is visually easy to recognize how the contractions and expansions occur on the indicator.
Figure 2: Bollinger band squeeze (contraction in the bands)
The bands contract of squeeze as the range of the price action starts to fall. This is usually found when the markets are consolidating and establish a sideways range.
The next chart shows the Bollinger band expansion.
Figure 3: Bollinger band expansion (rising volatility)
You can see that when the outer bands expand, moving in opposite directions, price starts to rise sharply. This is what a breakout looks like right after the Bollinger band squeeze.
By now it should be evident that the Bollinger band squeeze trading strategy is used to enter a trade ahead of a breakout that happens. Once the consolidation in price ends, traders can then take an appropriate long or short position in the security.
In the next section, we will look at the trading rules for the Bollinger band squeeze strategy.
Bollinger band squeeze – Trading strategy rules
The Bollinger band squeeze trading strategy is based on simple trading rules. Firstly, identify areas of consolidation which is identified by the squeeze or the contraction in the bands.
Once this set up is identified, you can plot visual identifiers such as horizontal lines and mark the high and low end of the range that occurs within the squeeze. After the price levels are identified, the next step is to wait for the breakout.
It is important to note that the breakout can happen in either direction. Therefore, traders need to be absolutely sure of the breakout direction. Once this is identified, you can then enter the trade in the direction of the breakout.
Another factor to bear in mind and one that is common to breakout trading strategies is that price action can at times post a fake breakout. A fake breakout is when price tricks you into breaking out in one direction, only to reverse direction and move in the opposite direction.
The fake breakouts are common to breakout based trading strategies and this is something traders should be aware of. Even when using the Bollinger bands, it can be hard to predict the fake breakouts.
The chart below shows an example of the Bollinger band squeeze long trade.
Figure 4: Bollinger band squeeze – Long set up example
In Figure 4, you can see that the set up occurs after the bands start to squeeze. This comes near the low end of the price. As the Bollinger bands contract, you can see that price action turns sideways and moves in a range.
This is the first cue for the trader to get their set ups ready. After the high and the low is identified during the Bollinger band squeeze, you wait for the bands to expand and for a breakout to occur.
The strong bullish candlestick you see on the chart shows the breakout. Once the breakout is confirmed, you can take a long position on the start of the new session after the breakout.
The stops are placed at the low and the target levels are set to 1:1 and 1:2 risk reward set ups.
Sometimes, you can see that following a breakout, price tends to retest the breakout level to establish support. While it is a good idea to wait for the retest, these occur rarely and waiting for such signals could leave you out from profitable trading opportunities using the Bollinger band squeeze trading strategy.
Now let’s take a look at trading a short position with the Bollinger band squeeze strategy.
Figure 5: Bollinger band squeeze – Short set up example
In Figure 5, we can see a short position that is taken. The rules are similar to the ones presented in the long position.
Firstly, identify the area of Bollinger band squeeze. Following this set up, plot the high and the low levels of the range. When the breakout occurs to the downside, you can then take a short position at the open of the next candlestick.
Using a 1:1 and 1:2 risk reward set up, you can then manage your positions accordingly. Note that price does not always reach the 1:2 profit level as seen in the example in Figure 5. Therefore, the Bollinger band squeeze strategy requires an active management of your trades.
One of the ways to validate the direction of the breakout is to look at the slope of the bands that emerge after the breakout. If you see that despite the expansion, the outer and the middle Bollinger bands are sloping up, then it is a good sign that the breakout will continue to the upside.
Similarly, if you see that the bands are sloping downward after the breakout, then you can more validation to the short position.
There is also the Bollinger band squeeze indicator which is derived from the Bollinger band itself. This indicator can be used to identify when there is a squeeze or an expansion in the Bollinger bands. The indicator works as an oscillator and prints in the sub-window of the chart.
If you feel that it is difficult to identify the Bollinger band squeeze, you can search for the Bollinger band squeeze indicator.
This trading strategy can be further expanded by looking at multiple timeframes for additional validation. However, at the same time, multi-time frame analysis can also increase the complexity of the trading strategy as simple as this.
Bollinger band squeeze trading strategy – Summary
In summary, the Bollinger Bands indicator is one of the default and easy use to technical trading indicators. It is a two in one indicator as it shows not just the trend but also periods when price consolidates and breaks out.
The Bollinger band is widely used when it comes to breakout trading strategies. Thus, the Bollinger band squeeze is nothing but a breakout trading strategy. The strategy is simple as outlined in the above sections.
Traders can apply this strategy to daily or even small time frame charts. While it requires a bit if practice, the Bollinger Bands squeeze trading strategy can be traded as is, using just the Bollinger Bands or you can also use other indicators for additional validation.
One of the key things to remember when using the Bollinger Bands is that you do not need to add another moving average. This is because the indicator is itself derived from the 20-period simple moving average indicator.
There is flexibility to change the settings of the moving average and also the standard deviation settings which usually defaults to two. Some traders for example change the standard deviation based on the values calculated from the Average True Range indicator, also known as the ATR.
Because the ATR aptly captures the true range of the da and gives an average value over a period of time, the standard deviation of the Bollinger band can be set to the ATR value to get a better reading and more appropriate for the markets that you are trading.
No two securities behave the same way when it comes to aspects such as momentum and volatility. Therefore, customizing the Bollinger Bands is a great way to get more familiar with the Bollinger band squeeze trading strategy.