Bollinger Band® Channel Trading Strategy

Discussion in 'Trading Strategies' started by Dary, Nov 6, 2013.

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  1. Dary

    Dary Dary McGovern Staff Member

    Bollinger Band Channel Trading Strategy Overview

    Bollinger Bands provide a definition of high and low price ranges, relative to price volatility. By definition if the price rises above the Upper Bollinger band line then the price is considered to be at a high, and if the price falls below the Lower Bollinger band, the price is consider to be at a low. The Bollinger Bands Channel Trading Strategy is based on trying to trade the price channel that exists between the Upper and Lower Bollinger Bands.

    The Bollinger bands are based on the range of price movement relative to the Moving Average. The number of Standard Deviations is used to calculate the upper and lower bands relative to the Moving Average. One standard deviation represents 68.2% of the range of price movement relative to the moving average; two standard deviations represent 95.4% of the price movement relative to the moving average and therefore only excludes the extreme highs and lows during the period; three standard deviations represents 99.6% of the price movement.

    The Bollinger Band Channel Trading Strategy is based on the following criteria:

    Long Positions:
    • Switch to a long position if the Low price spikes below the Lower Bollinger Band and the price then closes above the Lower Bollinger Band
    • Close the long position if the High price touches the Upper Bollinger Band

    Short Positions:
    • Switch to a short position if the High price spikes above the Upper Bollinger Band and the price then closes below the Upper Bollinger Band
    • Close the short position if the Low Price touches the Lower Bollinger Band

    The strategy is based on the default Bollinger Band settings of 20 periods and 2 standard deviations, using a 5 minute chart interval. The GBP/USD was chosen as it tends to be more volatile than for example the EUR/USD, which helps to highlight the strengths and weakness of the strategy.


    Bollinger Band Channel Trading Strategy Execution

    The long entry alert has two triggers, both based on 5 minute intervals, as illustrated:

    Bollinger_Band_Trading_Channel_1.png

    The triggers are in a Group and both trigger events have to occur within 1 second of each other, which means that in this example a 5 minute candle must spike below the Lower Bollinger Band and then close above it. Click here to learn more about grouping and sequencing alert triggers.


    The requirement for the low price spiking through the Lower Bollinger Band is important, because there tends to be a higher probability of a reversal in the price action if a candle retreats from a new low (or high for the alternative Short Entry illustrated below).


    The trade associated with the Long Entry is based on a 'Buy Switch' if not already in a long position as illustrated:

    Bollinger_Band_Trading_Channel_5.png

    The Buy Switch will buy to close a short position, if it exists and then buy to open a long position. Note that the alert reactivation period is set to 1 hour and this is to prevent repeated purchases if the price is in a strong downward trend after a long entry.

    If using this strategy pay careful attention to the normal time frame between successful trades and set the alert reactivation time frame accordingly. This becomes increasingly important if a stop order is added to the buy switch opening trade; if the price falls rapidly the alert could repeatedly buy to create a long position and then stopped out, resulting in a series of consecutive trades that are stopped out while the market is in a strong downward bearish trend.

    The closing long position is based on selling if the High price touches the Upper Bollinger Band as illustrated:

    Bollinger_Band_Trading_Channel_6.png
    Note that the alert trigger is set to check if the High price crosses over the Upper Bollinger Band on each tick during the interval. This will result in a trade being execute during the interval, rather than on the close of the interval, in order to attempt to maximise profits. If using this strategy, should the price tends to close above the Upper Bollinger Band, the check the trigger on the interval close rather than on each tick.


    The trade associated with the Long exit is based on selling if in a long position as illustrated:

    Bollinger_Band_Trading_Channel_4.png


    The Short Entry strategy is configured in the same manor as the Long Entry strategy:

    Bollinger_Band_Trading_Channel_3.png

    and the short exit strategy:

    Bollinger_Band_Trading_Channel_2.png


    Bollinger Band Channel Trading Strategy Analysis

    The strategy works best when the markets are trading sideways or mildly trending in a given direction, however it fails when there is a strong trending move as illustrated (up arrows are 'buy'; down arrows are 'sell'; grey arrow is an opening trade; green is a profitable trade; blue is a losing trade):

    2013-11-6_CX-GBPUSD.jpg

    From analysing the trading performance the key characteristics of this strategy are that the Average Reward tends to be significantly less than the Average Risk, however if the market is not strongly trending, typically the Win Loss ratio is in excess of 50% as illustrated from the backtest results:

    Bollinger_Band_Trading_Channel_7.png


    Note the heavy loss at the start of the backtest period due to the strong direction price move as illustrated in the chart above. As the price action settled down the strategy gradually recovered. In the following backtest analysis, note the concentration of green profitable arrows during the periods of sideways trading and how the blue arrows representing losing trades are associated with the stronger directional moves:

    2013-11-6_CX-GBPUSD (1).jpg

    As with any strategy, ensure it is forward tested for the markets you wish to trade to build a clear picture of the risk reward profile while analysing when the strategy works and when it doesn't.


    Bollinger Band Channel Trading Strategy Conclusion

    The strategy is better suited to sideways trading market conditions and complements trending strategies such as MACD Crossover Strategy. The job of the trader is to pick the right strategy for the prevailing market conditions.

    The Win Loss Risk Reward profile tends to be small frequent wins during periods of sideways trading, therefore when back testing consider spread or commissions on the overall profitability. The timetotrade back testing feature includes the ability to add commission and slippage.

    The strategy can result in significant losses if there is a strong breakout or the market gaps. The immediate temptation is to put in place a stop at for example 10 or 20 points when the opening trade is executed, however that does not always generate the result you might expect. The use of stops and a short alert reactivation time frame, can result in repeatedly entering long or short positions then stopping out if the market is making a strong directional move.

    The second consideration with stops is that it can be the case that it is better to sell at a point of strength, rather than repeatedly stopping out. When forward testing this strategy, run concurrent versions with and without stops over an extended period of time to develop a clear picture of the overall risk and reward. It is essential that your strategy is tested during volatile periods with strong directional moves to establish the underlying risk versus reward of both approaches. Also carefully consider the impact of not having a stop and ensure that you have enough margin reserve to deal with the significant loss that might arise.

    The following posts will discuss some methods for dialling out bad trades when the market starts to trend.
     

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  2. Dary

    Dary Dary McGovern Staff Member

    The Bollinger Band Channel Trading strategy is better suited to range bound sideways trading markets. A way of establishing if the market is trending or trading sideways is compare the current value of a Moving Average to its past value. Rather than simply subtracting the current Moving Average from the Past Moving Average value, a more elegant approach is to look at the gradient as that removes variations in price values as the Moving Average trades between higher and lower price ranges.

    The gradient of a line can be determined by subtracting the current from the past value and then dividing by the number of candles that the past value is based on as illustrated:

    2013-11-6_CX-GBPUSD (2).jpg

    A custom indicator can be quickly built to calculate the gradient using the chart settings as illustrated i.e. subtract the current Moving Average from a Past Moving Average and divide by 20 candles as the Past Moving Average is 20 candles in the Past:
    Gradient_1.png


    This indicator can be imported along with the Bollinger Bands used in setting up this strategy with the import code: 4051-DA29-DD4B. Click here to learn how to import custom indicators.

    As illustrated in the following screen shot, the profitable trades tend to be associated with periods when the gradient tends towards zero:

    2013-11-6_CX-GBPUSD (4).jpg

    The Long and Short Entry trades can therefore be modified to only execute if the Moving Average Gradient is within given limits. To add the additional alert triggers, use the Moving Average Gradient chart triggers:

    Gradient_2.png

    Modify the Moving Average alert triggers so that the Gradient should be below the upper boundary and above the lower boundary as illustrated (an easier implementation is to create an indicator based on the absolute value of the moving average gradient as only one additional alert trigger would be required):

    Gradient_3.png


    The long and short entry trades should now look like the following examples:

    Gradient_4.png

    Short Entry:

    Gradient_5.png

    Back testing this strategy generates a better trade profile, with an improved Win Loss and Reward to Risk ratio as illustrated:

    Bollinger_Band_Trading_Channel_8.png

    From viewing the trades on the chart, the trading activity is better grouped around periods of sideways trading:

    2013-11-6_CX-GBPUSD (5).jpg

    This strategy still is exposed to significant losses if there is a strong trending move or the market gaps and you are on the wrong side of that move. A possible solution is to set up alerts that will close positions if the gradient increases beyond an outer limit as illustrated:

    Gradient_6.png
     

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  3. Dary

    Dary Dary McGovern Staff Member

    Given that the Bollinger Band Channel Trading strategy is best suited to periods of sideways trading, an effective mechanism to prevent significant losses when there is a change of trend, is to set up upper and lower trend line alerts that will pause the trading strategy when the price breaks through them. To do so, once you have started the Bollinger Band Channel Trading strategy, draw your support and resistance trend lines and set up alerts that will close open positions and pause the strategy if they are broken.

    To create an alert for example that will close a short position if the price breaks through resistance, select the trend line and use the chart triggers as illustrated:

    Bollinger_Band_Trading_Channel_9.png

    Associate the trend line alert with a trade to buy to close the short position, if there is a short position and then 'pause active alerts'. If there is no open position, the alert will simply pause the active Bollinger Band alerts:

    Bollinger_Band_Trading_Channel_10.png

    Repeat the process for the support trend line as illustrated:

    Bollinger_Band_Trading_Channel_11.png
     

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