Using Bollinger Bands and ADX Signals - Part 1/2
Updated: Sep 19, 2020
If there is one thing that a trader would want to know for certain, it would be to pinpoint the bottom or top of a trend. But simple as it sounds, it is easier said than done. Knowing that a certain price wave is completed, or is just a retracement in the larger trend becomes more of an art than a science. In such situations, using multiple sources of confirmation helps to avoid the potential false signals, and preserve our capital for only those situations that provide us with the most favourable risk to reward scenarios.
Keeping that in mind, we will use two very different indicators – the Bollinger Bands and the ADX - to form a system which should help us to “catch a falling knife.” Bollinger Bands is an indicator that allows users to compare volatility and provide a relative definition of high and low.
The indicator consists of three bands which usually to encompasses the majority of price action.
A simple moving average in the middle
An upper band (SMA plus 2 standard deviations)
A lower band (SMA minus 2 standard deviations)
The basic interpretation of Bollinger Bands is that prices tend to stay within the upper and lower band. Because standard deviation is a measure of volatility, Bollinger bands adjust themselves to the market conditions. When the markets become more volatile, the bands widen (move further away from the average), and during less volatile periods, the bands contract (move closer to the average). The tightening of the bands is often used by technical traders as an early indication that the volatility is about to increase sharply.
Following are the characteristics of Bollinger Bands.
Sharp price changes tend to occur after the bands tighten, as volatility lessens.
When prices move outside the bands, a continuation of the current trend is implied.
Bottoms and tops made outside the bands followed by bottoms and tops made inside the bands call for reversals in the trend.
A move that originates at one band tends to go all the way to the other band. This observation is useful when projecting price targets.
Based on these, one may go long or buy the market below the lower band while selling short the market above the upper band. However, this can become a dangerous proposition if the market develops a strong trend, and price starts “walking the band” creating new extreme price levels. To counter this disadvantage of the Bollinger Bands, we shall use the ADX indicator.