One of the best tools for gauging the volatility of the markets is the one developed by John Bollinger in the early 1980’s and named simply, Bollinger Bands. This tool has the ability to contract when the market is slow and quiet and expand when the market moves like a rocket. In a previous article regarding the Bollinger Bands, we told you not to trade in the zone where you see the Bands contracting more than usual because a strong move is next. Well, the strategy that we are presenting today tries to identify the direction of the strong move that follows. And it does so by using the Moving Average Convergence Divergence indicator, commonly known as MACD. Volatility can be good for the trader, but it also implies more risk, because if price goes in the opposite direction of our trade, the Stop Loss will be quickly hit so we must use good money management rules when we are trading a volatility strategy like this one.
After plotting Bollinger Bands and MACD on our charts, both with default settings, we must wait for a contraction on the bands. Remember, the distance between the Bands changes almost all the time, but we need to see them contracting more than usual, until they form a very thin channel, containing price This contraction is commonly known as the Bollinger squeeze. After a Bollinger squeeze, we know for sure that price will move strong in one direction or the other. Then we must let the MACD give us an indication of where price will go. Here is a picture of what we are looking for:
In the picture above we can see the bands very close together and we know a strong move will follow. When price moves up, we see that the move is confirmed by the MACD lines which are moving up (same direction as price) and diverging. So now the move up on price is confirmed by the MACD and we can take a long trade. Also, we must previously see a Bullish cross of the MACD lines. This means that the fast line must cross the slow line going up. In our trade example, the Bullish cross already occurred.
Ok, now that we are in a trade, we must manage it and find a way to minimize risk but at the same time, let a winner run for as much as possible. For this we will use a Trailing Stop Loss, but first things first: our Stop Loss goes behind the Support or Resistance level created by price while it was confined in the Bollinger squeeze. Here is the picture:
As for the Take Profit, that will not be predefined before we enter the trade, but when the trade moves in our favor by the same amount of pips as our original Stop Loss, we will move it to break even and set a Trailing Stop Loss of the same amount of pips. Here is an example: if for our trade we use a Stop Loss of 20 pips, when price moves in our favor by 20 pips, we will move the Stop Loss in the same place where our entry was (now we cannot lose anything on this trade) and set a Trailing Stop Loss of 20 pips. Using this technique, we will be in the trade for as long as price continues to move in our direction without retracing for 20 pips. If it retraces 20 pips, The Trailing Stop will close it automatically. Remember, our Trailing Stop stays 20 pips behind price as long as price moves in the desired direction, locking in profit.
Bollinger and MACD strategy summary:
- Wait for the Bollinger Bands to squeeze close together, with price inside them
- Look for a breakout in any direction
- MACD must agree with the direction taken by price and must have a previous cross that also agrees with our direction
- Stop loss goes behind the Support or Resistance created by price during the Bollinger squeeze, enough pips away to give the trade some room to move.
- Move to break even once the trade moved in our direction by the same amount of pips as the original Stop Loss
- Set a Trailing Stop Loss of the same amount of pips as the original Stop Loss
Bollinger and MACD strategy – advantages and disadvantages:
The MACD is sometimes lagging too much behind price and that can give a late signal, but on the other hand, the signal is pretty accurate in normal market conditions. However, this strategy just like all presented here must be thoroughly tested on demo accounts until you are comfortable with the rules and you see that it is profitable.