Trading With Bollinger Bands

One indicator, two strategies, opposite conclusions

Bollinger Bands plot a moving average, normally 20 periods, with an upper and lower band set two standard deviations away from it. Because standard deviation is a measure of recent dispersion, the bands widen when the market is moving and contract when it is quiet. That is the entire construction, and it supports two strategies that give directly contradictory instructions at the same moment.

The mean-reversion reading says a touch of the upper band shows price stretched beyond its normal dispersion, so expect a pull back toward the middle. The volatility-breakout reading says a squeeze followed by a push through the upper band shows a new move beginning, so expect continuation. Both are used. Both work in the conditions they were designed for. The trader who has not decided which one they are trading before the touch happens will pick whichever feels right at the time, which is not a strategy.

Two standard deviations, and the 100-pip box it draws

Take EUR/USD with a 20-period average sitting at 1.0900 on a 1-hour chart and bands at 1.0950 and 1.0850, a 100-pip envelope. Volatility falls over the next two sessions and the bands contract to 1.0920 and 1.0880, a 40-pip envelope. The average has barely moved. What changed is dispersion.

• Mean reversion inside the wide envelope: a touch of 1.0950 with the bands wide and the average flat is a fade candidate, targeting 1.0900, risking a stop above 1.0965.
• Breakout from the narrow envelope: price closing above 1.0920 after a 40-pip squeeze is a continuation candidate, targeting the width of the prior consolidation, risking a stop back inside it.

Notice the two setups are distinguished by band width, not by the touch. The touch is the same event. Under two standard deviations, price spends most of its time inside the bands by construction, which is a statistical property of the calculation rather than evidence that the market is about to turn.

Band walking, and the trade that keeps being wrong

In a strong trend, price does not touch the upper band and retreat. It rides it, closing near or on the band for candle after candle while the whole envelope drifts higher. This is called walking the band, and it is the failure mode of naive mean reversion.

A trader fading the first touch at 1.0950 is stopped at 1.0965. Fading again at 1.0980 is stopped at 1.0995. Three attempts of that kind during a single trending session costs three stops in exchange for the eventual pullback, which may arrive 150 pips higher. The tell is available in advance: the middle band is sloping rather than flat, and the closes are clustering in the upper third of the envelope. When that is the picture, the bands are describing a trend and the reversion logic does not apply.