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How to Use Bollinger Bands in Futures Trading

Originally published at: https://optimusfutures.com/tradeblog/archives/bollinger-bands-futures-trading/%20

The following article on Bollinger Bands is the opinion of Optimus Futures.

Any movement in asset prices implies some level of volatility. If price is barely moving, volatility is still present but low. When price really gets moving, volatility increases. And when prices begin fluctuating up and down in jagged waves, whether trending or ranging, then volatility is high. But how might you measure whether price volatility has exceeded the average? After a large price move, at what point might prices have gone too far , implying a possible reversion to the average?

That’s what Bollinger Bands are designed to help measure.

What are Bollinger Bands?

Created by John Bollinger in the 1980s, Bollinger Bands are an indicator used to help monitor the volatility levels of a security’s price–be it a stock, futures contract, or anything else that trades on the market.

Standard Bollinger Bands have three components:

There’s a moving average [1] traditionally set to a 20-day moving average (this can be adjusted to any MA length). There’s an upper band [2] that’s traditionally set to a 2nd standard deviation from the average. And finally, there’s a lower band [3] set to a 2nd standard deviation from the average. All these settings are adjustable, and additional bands can be added to reflect smaller or higher standard deviations from the moving average.

How to Use Bollinger Bands in Futures Trading

Bollinger Bands are popular tools for analysis and trading because the bands are designed to automatically adjust to the volatility currently being experienced in a particular market. In short, Bollinger Bands “listen” to the market, self-adjust and allow traders to plan their trades accordingly. They may be used on intra-day, daily, weekly and even monthly charts. Just be careful to understand how changes in time scale alter the volatility environment of a given asset .

Since many of you are day traders, let’s look at Bollinger Bands on an intraday scale.

A 15-minute chart of the E-mini S&P 500 (ES) contract is presented with a 2-standard deviation Bollinger Bands overlay using a 20-period simple moving average. While there are many valid interpretations of Bollinger Bands (if it works – use it,) several common characteristics of markets analyzed using them are:

  • [1] Sharp price changes tend to occur after the bands tighten, after volatility lessens (the Bollinger Squeeze).
  • [2] Price sometimes reverts to the average after an explosive move beyond the 2nd or 3rd (not shown here) standard deviation (the Bollinger Bounce).
  • [3] A move beyond the bands tends to imply a subsequent continuation of the trend.
  • [4] A move that touches one band can sometimes go all the way to the other band–an observation that may be useful when projecting price targets.

While these are not hard and fast rules, they do give traders insight into where prices may head soon. We will examine each of these scenarios using our 15-minute ES chart.

The Bollinger Squeeze

The Bollinger Squeeze is a visually derived concept suggesting that lower volatility tends to be followed by an explosive move. Why is it called a “squeeze”? Because it appears as if volatility is being constrained within a narrow range of movement resulting in a reaction of sharp movement.

For example, on the evening of September 18, 2019, the ES entered a period of low volatility following the previous day’s US Federal Reserve rate cut. As you can see at (as shown by the green arrows), the bands narrowed as they usually do during this period prior to the NYSE open.

Traders observing the bands might have expected sharp movements following the opening–plus other reports later in the day, such as jobless claims, the Philly Fed manufacturing index, and existing home sales report.

As soon as the NYSE opened–remember, it’s the underlying index upon which the ES is based–the market jumped. Naturally the volatility constraint (the “squeeze”) reflected the period before the response–a reaction to both the previous day’s news and current or impending news (economic reports).

Luckily, Bollinger Bands can help indicate a measure of the likelihood of such movements.

The Bollinger Bounce

The Bollinger Bounce is the notion that price tends to “bounce” off the 2nd or 3rd standard deviation. As prices don’t move in one direction only, 2nd and 3rd standard deviations are often looked upon as potential support and resistance.

Is the “bounce” a reliable thesis? It depends, particularly with regards to time frame. On a daily chart, movement percentages tend to reflect the larger macro-trending environment, which has closer ties to economic fundamentals. On smaller time frames, say, 1-minute to 1-hour, market noise tends to be more prevalent, making such rules (e.g. the “bounce”) less reliable on a fundamental level, yet self-fulfilling on a technical level (as intraday traders tend to trade based on technicals, hence effectuating price movements that reflect technical sentiment rather than economic drivers).

Bollinger Bands Strategy | How to Spot Trends And Trend Reversals

When Price Moves Outside Bands, Look for Continuation

Once price and volatility expands toward a sharper contraction after a period of constriction, price movements beyond one side of the band can often signal the potential for continuation as shown above.

Eventually, price reverts to the average (as nothing can go up or down indefinitely), sometimes touching the opposite band. This brings us to another common feature of markets analyzed using Bollinger Bands.

Moves Starting at One Band Tend to Continue to the Other

The use of Bollinger Bands alone may not provide adequate information to anticipate directional movement, so pairing it up with other technical indicators (such as the Relative Strength Index, or RSI) can help you identify key price levels and potential reversals.

Traders who successfully bought this “oversold” level might have placed a profit target at the upper band. Also, those who were keen enough to identify the RSI and price divergence might have gone short the ES (setting the lower band as a profit target) or as a signal to re-enter a long position once the lower band had been touched.

Identifying Trends and Reversals on a Larger ScaleLet’s address the likelihood that many day traders trade market noise. If you’re trading market noise, then the idea of “trends” or “reversals” can sometimes be close to meaningless as noise often means “randomness.”

So, to spot trends, you may need to take a step back and look at the larger movements.

As you can see above, price divergence on a larger scale can sometimes provide more meaningful data–in this case, it indicates a reversal. Following the reversal, price continued in the direction of the trend. So what happened to the previous principle that price movements beyond the Bollinger Band tend to continue? On a larger time frame, this may be true, but again we’re looking at the 15-minute chart, in which case many of John Bollinger’s concepts may be too drowned out by noise that they’re rendered somewhat moot.

Remember, what matters in the end are macro–trends. Fundamentals and investor sentiment drive prices with fundamentals coming out the clear long-term winner. The smaller the time frame, the noisier the time frame. The noiser the time frame, the more random the moves. The more random the moves, the closer one’s “trading” gets to “gambling.” Anyone who says otherwise is selling you a false notion.

The Bottom Line

The possible uses of Bollinger Bands are almost limitless and not confined merely to futures markets: they can be used to analyze almost any series of data. However, using Mr. Bollinger’s original interpretation, especially when combined with other indicators, such as the RSI and price-volume analysis, as well as fundamental analysis, traders are provided with a powerful tool to potentially help make well-informed technical trading decisions.

Please be advised that trading futures and options involves substantial risk of loss and is not suitable for all investors. Past performance is not necessarily indicative of future results. This matter is intended as a solicitation to trade.

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Trading on a 15 minutes time frame, would you still consider a 20-period simple moving average the best fit for the time frame?

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@cwoods20,
It all depends on your trading style, intensity and profit to loss ratios you are using.
Trial and error.
Happy Trading,
-P11

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When it comes to trading, it would be hard to apply “best”. First, that is because every trader could have a different comfort level when it comes to his/her technical indicators and time frames. A nondisciplined trader could imitate a professional setup and still achieve different trading results.

A professional trader applies risk management in a manner that he/she “max out” the information in front of him/her. Therefore, it is not always the time frame or the indicator you use, but how you use the information that us in front of you.

So please trust the set up you are using if it does works for you, and you are improving your trading.

Having said the above, please consider this: Maybe you should look at multiple time frames. As you know, there are three primary trends: primary, intermediate, and short term. Depending on the Futures Contract that you trade, there could be conflicting trends between the time frames. For example, the primary trend could be trending up while the intermediate and short-term are trending down.

Sometimes Futures traders focus on a specific time frame, ignoring the more robust primary trend. Alternately, traders may be trading the primary trend but do not refine their entries to match the short term time frames.

A day trader could trade the 15-minute charts )as you are doing now), but also add the use 60-minute charts to define the primary trend and a five-minute chart (or even a tick chart) to identify the short-term trend. In my opinon, you should always have a time frame above and below your current time frames so you do not get caught in the noise of your short term futures trading strategy.

Thanks,

Matt Z
Optimus Futures

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