Using Bollinger Bands and ADX Signals - Part 2/2
Updated: Sep 19, 2020
Our objective is to use a combination of Bollinger bands and ADX signals to pinpoint the bottom or top of a trend. 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 basic interpretation of Bollinger Bands is that prices tend to stay within the upper and lower band. Traders 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.
The ADX indicator measures the strength of the current trend, rising during extreme trending states, and falling as the market retraces in a range-bound state. The ADX line has definite advantages because it filters out a lot of the false oscillator signals which are frequently given early in a move.
It is this last feature of the ADX that we shall combine along with the Bollinger bands. If we were looking for a downtrend to end, we would look for price to thrust outside the lower Bollinger band, by reaching an extreme oversold level. This by itself may not be the confirmation that the trend has run out of strength. But at this point, if the ADX starts declining from its overbought values, then we have a better probability of the momentum change. The market then reaches “a critical turning point” as the ADX turns back to the downside, while the price falls below the lower Bollinger Band.
Let us observe the use of this strategy on the following chart example.
The very first example (marked as the green circle.1), proves the effectiveness of this technique.
Price had been in a downtrend, and the Bollinger Bands signalled a reversal with the price closing inside the lower band.
By itself, this should have been a good signal to go long. But if we observe the ADX, it had not yet reached the overbought area, indicating that there is still some momentum left in the downtrend.
(The blue horizontal line on the ADX is plotted at the 40 levels, which is normally considered as an over-extended value of the ADX) And surely enough, this turned out to be a minor retracement with price resuming the downtrend.
We had a similar situation (at the blue circle.2) only this time the ADX had crossed over to the extreme overbought zone, and had started retracing down indicating the trend had weakened.