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4 Rules For Using Double Bollinger® Bands To Avoid Buying At The Top

|Includes:FXE, SPDR S&P 500 Trust ETF (SPY)

A Short Illustrated Primer On How To Use Double Bollinger®Bands To Avoid Buying At The Top Or Selling At the Bottom

This is part of FXEmpire's continuing series of special features on trader education, and provides a solid basis for understanding double Bollinger bands.

From late 2007 to mid-2011, gold kept hitting new highs. Those seeking an entry point had no prior support and resistance for guidance, and so many delayed and missed what were ultimately cheaper entry points? How could they have identified lower risk entry points, or at least gotten some assurance that they weren't buying at the top? When that top came, how could they have more easily identified it?

Today, many stock investors face the same dilemma. For example, the S&P 500 remains near its all-time highs.

(click to enlarge)Click to enlarge

Chart A: S&P 500 Weekly Chart, From Week Starting March 24 2013 to Week Starting March 24 2014

Key: Yellow Bollinger®Bands: Settings Of 2 Standard Deviations, 20 Periods

Red Bollinger®Bands Settings Of 1 Standard Deviation, 20 Periods

Center Red Line: 20 Period Simple Moving Average

01 Mar. 27 12.35

Does the bull market still have life in it?

With US and other stock indexes, and other global asset markets, at or near all-time highs, here's a helpful tool to avoid buying at the top (and also selling at the bottom).

The following is a brief illustrated summary of the 4 rules for using double Bollinger bands (DBBs), and their application to Chart A above.

Like any technical indicator signals, these should be confirmed by your preferred combination of technical and fundamental evidence. For background information, full details and illustrations of each rule, see our articles here and here. For a video introduction to double Bollinger®bands based on my book, see fxacademy's free coursehere. For more detailed coverage, and examples, see Chapter 8 of the book, The Sensible Guide To Forex.

RULE 1: Go Short & Stay Short, When Price Is In Or Below The DBB "Sell Zone"

When price is in the sell zone, downward momentum is strong enough for the odds to be in favor of continued downtrend. This rule applied from the week of September 7th (arrow A) until the week of December 14th (arrow B) in Chart 1 below.

(click to enlarge)Click to enlarge

CHART 1: S&P 500 Weekly Chart Sept. 7th - Dec. 14th 2008 - SELL ZONE Framed By Arrows A and B Within Highlighted Area

Source: MetaQuotes Software Corp, www.fxempire.com,www.thesensibleguidetoforex.com

01 Feb. 25 20.10

RULE 2: Go Long & Stay Long, When Price Is In Or Above The DBB "Buy Zone"

When price is in the buy zone, upward momentum is strong enough for the odds to be in favor of continued downtrend. The rule applied for most of the period between arrows 1-4 in Chart 2 below.

(click to enlarge)Click to enlarge

CHART 2: S&P 500 Weekly Chart March 8 2009 - April 4, 2010 BUY ZONE Framed By Arrows 1 To 4 Within Highlighted Area

Highlighted area: April 19, 2009 - 31 January 2010

Source: MetaQuotes Software Corp, www.fxempire.com,www.thesensibleguidetoforex.com

06 Mar. 24 12.45

RULE 3: Don't Trade Trends Based On DBBs When Price Is In The Neutral Zone

When price is in the middle, neutral zone, momentum isn't strong enough for trend trading in your current time frame.

Instead:

  • Trend Traders Should Cease Trading: Wait for the next entry into the buy or sell zone when momentum is strong enough.
  • Switch To Range-Trading Strategies: As we discuss in our book, in these situations it's especially helpful to also look at the range using a shorter term time frame, typically a fourth or fifth of your normal time frame. For example, those using weekly charts consult daily charts, and those using daily charts consult 4-6 hour charts.

For example, see the period between (but not including) arrows 5 to 8 in Chart 3 below.

(click to enlarge)Click to enlarge

Chart 3: S&P 500 Weekly Chart, January 31, 2010 - February 20, 2011 NEUTRAL ZONE is area between (but not including) Arrows 5 To 8 Within Highlighted Area

Red Arrows Highlighting weekly candles of April 25 (5), 2010, May 16, (6), August 1 (7), Sept. 12 2010 (8)

Source: MetaQuotes Software Corp, www.fxempire.com,www.thesensibleguidetoforex.com

12 Feb. 19 18.25

Rule 4: Minimizing Risk: Enter Longs At Bottom Of Buy Zone, Shorts At Top Of Sell Zone, Or Enter In Stages

The purpose of this rule is to minimize your risk of buying at the high or selling at the low.

For example, enter near or at the red Bollinger bands of the Buy and Sell Zones shown in Chart 4 below.

(click to enlarge)Click to enlarge

CHART 4: S&P 500 Weekly Chart August 17, 2008 to October 3 2010

Source: MetaQuotes Software Corp, www.fxempire.com,www.thesensibleguidetoforex.com

14 Feb. 19 19.58

In other words, arrow A indicates a low risk point to enter a new short position. Arrows 1, 2, 3, show low risk entry points for long positions. See Part 2 for details.

The Big Qualification To Rule 4

Do not attempt 'bargain hunting' if your full range of fundamental and technical evidence suggests that the move isn't just a technical pullback but instead the start of a trend reversal. If so, then avoid the trade, or take only partial positions until the trend resumes, and use conservative stop losses to minimize damage if in fact the trend you're playing breaks down.

For example, in Chart 4 above, this bargain hunting strategy worked for taking new long positions around the times of arrows 1, 2, and 3, but not around the times of arrows 4 and 5.

Applying The Above Rules To The S&P 500 Today: New Long Entry Point?

Given the above rules, the current level of the S&P 500 shown in Chart A above suggests we're at a good relatively low risk entry point. If price makes a decisive move below the buy zone, we know right away the trend has lost momentum and we can exit with a small loss by setting a stop loss just below the buy zone. Again, you'd have to weigh your other technical and fundamental evidence.

For full explanations of double Bollinger ®bands and their uses, seePart 1 and Part 2. For a video introduction to double Bollinger ®bands, see fxacademy.com's course, based on the material from my book, here.

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DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Stocks: SPY, FXE