Most traders from every background have heard of Bollinger Bands.
However, far fewer traders understand what they are or the best ways to use them to study the financial markets.
The inventor of the Bollinger Bands, John Bollinger, had one use that stood out above the rest.
This was the Bollinger Bands Squeeze Strategy, as detailed in his book, Bollinger on Bollinger Bands.
This strategy uses standard deviation bands to measure volatility.
Periods of extremely low market volatility tend to lead to periods of extremely high volatility.
These periods of high volatility tend to manifest in significant price breakouts.
Therefore, this strategy can be used to identify powerful price breakouts that can be exploited for significant profit.
Key Takeaways
- The Bollinger Bands Squeeze Strategy looks for periods of extremely low volatility using the Bollinger Bands indicator.
- Periods of extremely low volatility often precede significant price breakouts, which can be forecasted using the strategy.
A Breakdown of the Bollinger Bands Squeeze Strategy
Bollinger’s breakout strategy is a superficially simple one, but it requires some depth of analysis to get it right.
The basic focus of the strategy is the Bollinger Bands.
These volatility bands are a technical analysis tool that is composed of 3 lines.
- The middle band that represents the Simple Moving Average (SMA) of the stock’s price.
- The upper band plotted 2 positive standard deviations away from the SMA.
- A lower band plotted 2 negative standard deviations away from the SMA.
The bands represent the volatility of the stock’s price over the chosen time frame.
The theory behind the strategy is that periods of extremely low volatility tend to squeeze the price.
When a price is squeezed for an extended period of time, that squeeze effect tends to be released in a powerful breakout of high volatility away from the middle band’s trading range.
However, this does not indicate which direction the price breaks, which is where most traders struggle with this strategy.
While the squeeze effect can be visually perceived by observing the price chart, many platforms also carry a Bollinger Bands Width indicator that offers a more quantitative analysis of the volatility squeeze effect.
Bollinger Bands Width
While many traders simply use the bands on the price chart to determine the squeeze effect, some traders prefer a more quantified approach.
These traders will use the Bollinger Bands Width indicator, which is available on most advanced trading platforms.
The Width indicator offers a quantifiable measure of the distance between the upper band and lower band on the price chart.
Traders can then set an exact value for their squeeze effects instead of relying on the informal visual cues of looking at the bands on the price chart.
How to Use the Bollinger Bands Squeeze Strategy
Finding the squeeze effect using Bollinger Bands is simple enough, but the difficult part of the strategy is identifying the direction of the ensuing breakout away from the middle band.
John Bollinger suggested that traders will need to rely on additional technical indicators to identify trading signals for the direction of the breakouts in his strategy.
He suggested that momentum indicators, volume indicators and resistance levels were all complementary to this strategy.
However, any indicator that can identify reversals is useful for determining the direction of the breakout.
Bollinger also noted that the price tended to produce headfake price movements after a squeeze.
These headfakes occur when the price initially moves to a small degree in one direction before the true breakout happens in the opposite direction.
Breakout
The essence of the strategy is the squeeze leading to a breakout.
Traders must identify periods of extremely low volatility where the upper band and lower band move close together.
Then they must wait for the volatility to begin to climb as the upper band and lower band start to come apart.
The breakout quickly follows the initial climb in volatility coming out of the squeeze.
Headfake
The greatest danger in the strategy is when traders fall for the very common headfake price action as the squeeze ends.
Traders tend to assume that the initial price direction coming out of the squeeze will be the direction of the breakout.
However, this is very often not the case.
Therefore, traders need to confirm the direction of the breakout using additional supplemental indicators.
The initial price movements coming out of the squeeze are not a reliable indicator of the direction of the ensuing breakout.
The Best Tools for the Bollinger Bands Squeeze Strategy
While Bollinger Bands are available on most trading platforms, this strategy requires the use of supplemental technical analysis indicators to determine the direction of the breakouts involved.
Modern market research tools carry the full suite of technical analysis indicators, so traders can choose the exact right combination for every one of their trades.
The use of modern market research tools is essential to the development of robust and comprehensive trading strategies.
Our top recommendations for market research tools for retail traders are:
The Bollinger Bands Squeeze Strategy is simple in concept yet subtle in execution.
It is recommended that traders practice with this strategy extensively before using it on a live account.
Maintaining a trade journal is a necessary process for traders to learn from their practice trades.
Our top recommendation for trading journals for retail traders is: