Bollinger Bands are great at predicting upcoming price reversals. Here’s how you can build a countertrend strategy using its ‘free bars!’
The complete strategy can be downloaded in the Free Strategies section.
Bollinger Bands are the gift that just keep giving.
They’re simple and easily applicable to both trend following and countertrend strategies.
Here I’ll introduce yet another way to use Bollinger Bands to fade temporary overextensions.
Bollinger Bands in a Nutshell
Bollinger Bands consist of a simple moving average, with a pair of bands plotted at a standard deviation multiple above and below it.
By default, a 20-period lookback is used for the moving average, and 2 standard deviations are used for the bands.
If prices were normally distributed, they would close outside the bands only 5% of the time.
In reality, due to occasional price movers like economic reports and central bank decisions, I estimate the real figure to be between 10-15% of the time.
Fading Moves With the Bollinger Bands
Considering the figures above, it is reasonable to expect a prompt reversal when prices close outside the Bollinger Bands.
A close above the upper band indicates an overbought market, and is an opportunity to enter short. Conversely, a close below the lower band indicates an oversold market, producing a buying opportunity.
The baseline entry conditions are thus:
- Buy when prices close below the lower Bollinger Band
- Sell when prices close above the upper Bollinger Band
Of course, there’s a small possibility that the market will continue to rally or crash after the overextension.
As the famous quote goes:
The markets can remain irrational longer than you can remain solvent.
-John Maynard Keynes
How can we minimize the risk of catching a new market trend?
Since one losing trade can wipe out the profits from several winners, we seriously need to refine our baseline entry conditions.
Entry Filter #1: Free Bars
I first heard the term ‘free bars’ on Adam Grimes’ excellent blog.
These bars are completely outside the Bollinger Bands.
Since the entire bar has extended beyond the bands, a prompt rebound is likely to follow, much like a stretched rubber band snapping back into place.
From here on out, we’ll only use these free bars for entries. The conditions are now:
- Buy when the previous high is below the lower Bollinger Band
- Sell when the previous low is above the upper Bollinger Band
Entry Filter #2: Stop Entries
To improve the win rate, I want to see prices rebounding towards the Bollinger Bands before entering the market.
For long entries, a buy stop will be placed at the previous high. For shorts, a sell stop will be placed at the previous low.
Stop orders will be valid for 3 bars. If prices do not rebound within this time, there could be a fundamental impetus behind the price extension.
Entry Filter #3: Trade Asian Hours Only
Forex markets are open 24/5, but trading volumes vary significantly throughout the day.
Markets are busiest during the London and New York sessions, when high trading volumes often create and sustain trends.
It’s generally best to avoid these hours, so I’ll only take entries during the quiet Asian session.
I’ll only trade in the 2200 – 0400 range (GMT time).
During these quiet hours, there’s a higher probability that the price extension you’re exploiting is caused by noise. Noise is the random price movement that obscures underlying market direction. It is a result of the millions of market participants transacting for different agendas.
Such extensions are usually unsustainable.
In addition, if I enter a trade during the Asian hours, I don’t want it to be exposed to the high trading volumes when London opens.
I will close all open trades at 0400, which is the end of the trading time range above.
Programming the Bollinger Bands Free Bar Strategy
I input the trading logic in AlgoWizard.
The trade management inputs are at the bottom of the image.
I’ll use the middle of the Bollinger Bands as the profit target. In the absence of any fundamental price mover, you can quite reliably expect prices to revert to the mean.
I’ll use a relatively large stop loss of 50 pips. In countertrend trading, the average loss is usually much larger than the average win. The high win rate should make up for this though.
I then added the Asian hours time filter:
You’ll have to adjust the time inputs to match your broker time zone.
Backtesting the Bollinger Bands Free Bar Strategy
Your trading market is always an important decision.
I’ll trade the GBPCAD in this case. The GBP and CAD are generally risk-on currencies, so GBPCAD spends most of its time in trading ranges.
Lower timeframes typically contain more noise; I’ll look to exploit that by trading the 5-minute GBPCAD.
The 10-year backtest is shown above. Nothing really wrong with these results, except that 495 trades is a little low on the 5-minute timeframe. Well, at least it means the filters worked!
Or did they? Let’s find out.
Were the Entry Filters Useful?
I decided to redo the backtest, but with all the filters removed.
So the strategy now opens trades:
- When prices close above/below the bands (free bar not needed)
- Using market orders, not stop orders
- At all hours of the day
The profit target and stop loss were unchanged.
Not a disaster, but no way I’m trading that!
I always add some sort of entry filter when building a strategy from scratch.
In this strategy development article, you can check out these other types of filters:
- Day-of-the-week filters
- Long-term trend filters
- Volatility filters
Countertrend trading is a great way to diversify your portfolio and smoothen your overall equity curve.
Bollinger Bands can be a valuable addition to your countertrend strategy. You’ve probably seen these free bars lying around on your charts; hopefully you will now make use of them.
Alternatively, you can use Bollinger Bands together with reversal candlestick patterns to predict upcoming reversals.
Be sure to include a stop loss though, in case the market starts trending. Don’t let your trade become an investment!
The complete Bollinger Bands strategy can be downloaded in the Free Strategies section.