New trading strategies: here is a trading strategy from Bollinger Bands

Trading strategy: Bollinger Bands are certainly well known by many traders and they can be used profitably to build a winning trading strategy. In this article two authors provide you a somewhat unusual method of trading strategies that they picked up in the USA. You may be familiar with the term “to feather one’s own nest”. This is similar to the following trading strategy.

 Bollinger Bands trading strategy

The base of the trading strategy are the Bollinger Bands, which were developed in the 80’s by John Bollinger. Based on normal distribution, it emanates from the fact that current market prices of a bond with higher probability are situated near the mean value of the past market price rather than far away from it.

To identify market price trends, three values are used. First of all, average price is usually calculated with the 20 day moving average. Afterwards, the market price is “encircled” by two further bands calculated from the empirical standard deviation. The calculated standard deviation is multiplied with a predetermined factor (Bollinger recommends using a value of two) and this value is afterwards added or subtracted with the previously calculated average.

Modification of the Standard Parameters of this trading strategy

The authors use the Bollinger Bands with the following settings: Instead of the average price of the last  20 days, they will select the last 55 days (depending on the Fibonacci numbers). The standard deviation is changed from 2.0 to 0.2. They leave out the middle Bollinger Band. This gives them two very narrow bands, which they draw in blue.

Imagine now, that these bands were a river. These are therefore also shown in blue. This will enable you to better internalise the trading strategy. In this trading strategy indeed you wait until the candles have come completely to the other side of the river. It means that, the candle’s body must not touch the flow, which means that it may no longer be “wet”. Only when a complete candle stays outside the river and with it on the other side, also on the dry side, will we start with this strategy.

trading strategy 1

trading strategy 1

Market Entry, Stop and Risk-Reward Ratio (RRR)

You are entering into a long position when market prices have crossed the river from bottom to top. You buy a lot when exceeding the maximum rate of the first “dry” candle. The initial stop sits below the lower Bollinger Band. The stop should be a multiple of five pips, so choose at 17 pips distance from the market entry price 20 pips stop-loss. You measure this distance for the market entry price and then put your target   in the same ratio to stop or risk permanently. Your RRR is thus 1:1. For positions in the direction of the short side, the rules apply inversely. Various studies have shown that this trading strategy works well in the Forex market – particularly in the majors, so EUR/USD, GBP/USD, USD/JPY, USD/CAD and USD/CHF. The authors mainly choose the 15-minute  period as a time unit. They have not adequately tested other time units or markets, but this seems quite possible. You should not risk more than one to three per cent per trade with this method.

Now you might wonder, why first of all a RRR from 1.0 is chosen, although the authors have observed that the trend often continues more than the target. The authors have found that a position that they can continue to run often turns again in the opposite direction and thus gives back all profits. The trader should therefore use a stop-loss as a sort of trailing stop below the last candles as soon as 80 to 90 per cent of the movement to the target market price is achieved. This means that he gives back as little as possible from gains already achieved. This ensures that he only goes out of position when the trailing stop is reached. This has the advantage that it can definitely save a portion of the profits just before reaching the profit target. In Figure 2 we see that the position would have been stopped out at a loss, but it still comes out through a meaningful stop setting with a small profit from trade.

It is certainly difficult to find an ideal solution because you can never catch the optimal market entry or exit. In the following lines, the authors show some variants of this trading strategy. You can place these trades with the so- called “OCO order” (One Cancels the Other) or secured order. You don’t need to continue observing the trade. You can also simultaneously enter various trades in more underlying assets. The low margin  requirement for CFDs and Forex allows you to set up your portfolio in a diversified manner. For example, you can enter these orders early in the morning and go to work. In the evening you can see whether your target market price has been reached or not.

trading strategy 6

trading strategy 6

Three Per Cent Risk per Trade

Another modification is to apply the trading strategy with a fixed percentage risk per trade. One possibility would be risking three per cent per trade; it means that at a $10,000 account you risk $300 per trade.

So if the stop-loss lies at 20 pips, the position size is calculated as follows: $300 / 20 pips = $15 per pip. The lot size can be adjusted accurately to ensure that for each trade the same risk is taken, regardless of whether the stop stays at 20 or 50 pips away. Trading with a mini lot (10,000), 15 lots can be traded. In microlots (1000) it would be 150 lots.

Elimination of the Risk and Partial Exits

Market entry and provision of stop-loss take place as described above. The first take profit is set with half of the position at a RRR of 1:1 and the second half with a RRR of 1:2. Example: Stop-loss at 20 pips loss, first take profit at 20 pips profit with 50 per cent and the second take profit at 40 pips. After reaching the first profit target, you drag the stop to break-even, i.e. on purchase price. From now on you can’t lose with the overall trade. The aim of this approach is the elimination of risk for a little less profit.

In the classic use of the trading strategy with a RRR of 1:2, you get a potential gain of $600 in a risk of $300 per trade.

If you change your exits as described, you could achieve a maximum profit  of  450 dollars  and the risk is reduced to $0 (after reaching the first profit target). You sell half of the position at a profit of $150 and have the opportunity to win from it further $300.

trading strategy 3

trading strategy 3

More Alternatives

Use the same market entry and stop as before, then sell 50 per cent of the total position upon reaching the target profit of a RRR of 1:2. After reaching the target profit, you drag the stop to break-even. Exit to the second half of the position arises either, a) at break-even, or b) the closing market price of the first “dry” candle on the other side of the river (Bollinger Bands). You hereby secure a partial profit with the additional option of further gains from longer trend movements, thus feathering your nest.

Multi-Time Frame Approach trading strategy

Another interesting variant is the following trading strategy. You complement now your setup (15-minute chart) to another yellow Bollinger Band in the higher time frame of one hour with the same parameters (55; 0.2). This second Bollinger Band serves to generate market entry signals and the other as a trend filter. It’s traded in the 15-minute chart. As soon as the market price is above the yellow band, there is an upward trend. If the market prices are under the yellow band, the downtrend is intact. A trendless phase – a so-called sideways movement – occurs, if the market prices stay within both Bollinger Bands.

trading strategy 4

trading strategy 4

 

Market Entry and Stop-Lossin the trading strategy

This trading strategy is a combination of the blue and the yellow Bollinger Bands, which are shown as blue and yellow rivers. Once the market price breaks out of the yellow, you open a long position. The candle must no longer touch the band. The stop-loss is defined by the blue Bollinger Bands in the 15-minute time frame. This means that the long position is closed, as soon as the market price below the blue river closes, thus the Bollinger Bands. The candle must be a “dry candle”. Only such a signal is valid. Conversely, short positions are opened as soon as the closing market price of the 15-minute candle closes below the yellow river. The position is stopped out as soon as the market price closes above the blue river.

Re-Entry

There is furthermore the possibility that a signal is generated to re-enter a trade. Here, a new long position is opened as soon as the market prices close above the blue Bollinger Bands once again. Conversely, a short position is opened as soon as prices close below the blue band, wherein again the candle should not touch the Bollinger Bands.

Conclusion

This trading strategy presented here can be applied on the one hand in the classic, simple form; on the other hand, the optimisation’s opportunities arise through the addition of various filters.

Through the combination of different time frames, one can benefit from longer  lasting period of  trends as well as short term market price movements. Furthermore, the higher time frame is used as a filter to specify the direction of the trend for the smaller time frame. Then only trades are disposed to get into the overridden trend direction. This leads to an increased hit rate, since minor corrections are filtered out and consequently not traded.«

Article provided by www.traders-mag.it 

trading strategy 5

trading strategy 5

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About Author

Emilio Tomasini is Chief Editor of the Italian edition of TRADERS’ MAGAZINE (www.traders-mag.it), the leading monthly publication in Europe for trading and investment, and since 1999 he organizes the TRADERS’ CUP the most important real money European trading competition (www.traders-cup.it). His personal weekly free newsletter L’Indipendente di Borsa (www.indipendentediborsa.it) is one of the most reputable Italian financial media and counts more than 100.000 readers. His website in English is www.emiliotomasini.com

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