How do I create a trading strategy with Bollinger Bands® and the stochastic oscillator?
Traders who use Bollinger Bands to measure a security’s volatility often use a complementary indicator to help confirm possible price trends. Outside of the relative strength indicator (RSI), the most popular technical tool combined with Bollinger Bands is the stochastic oscillator.
The stochastic oscillator is a common momentum indicator used to compare the trading range of a security to its closing price over a period of time. Theoretically, a security’s price remains relatively close to its recent high during a bull movement. Conversely, prices remain near a recent low during bear movements. There are actually three versions of this oscillator, full, fast and slow, and each can be used alongside Bollinger Bands.
Bollinger Bands plot three bands on a price chart to create two price channels. The security is said to be overbought if the price line is consistently near or breaches the upper price band. It may be oversold if the price line is consistently near or drops below the lower price band.
The stochastic oscillator is plotted below the price chart and is made up of two lines, each within a range of zero to 100. The first line, called %K, is a raw measure of possible momentum. Trading signals are generated when %K crosses the second line, %D, which is a moving average of %K.
An overbought position is confirmed if the stochastic lines cross above 75 and the price line is consistently near the upper Bollinger Band. At that level, prices are expected to drop soon. The opposite is also true; a price line trading near the lower Bollinger Band can be confirmed with crossing the stochastic oscillator lines below the 25 mark.
How do I create a trading strategy with Bollinger Bands® and the MACD?
Technical traders look at many indicators and charts to develop trading strategies specific for each security. Many of the same tools these traders use can also help ordinary investors. With just a little background knowledge and understanding of how they work, you can make a profitable trading strategy using indicators such as Bollinger Bands and the moving average convergence divergence, or MACD.
Bollinger Bands, developed by technical analyst and trader John Bollinger, are a set of bands surrounding a security’s moving average that show standard deviation areas. For a security that generally fluctuates within a set range for long periods of time, creating a rectangle pattern on a chart, you can use Bollinger Bands to set up profitable trades. The buy and hold method provides little profit on securities that move sideways, but by buying at or near the lower Bollinger Band and setting limit orders to sell at or near the upper band, you can capitalize on the price fluctuations. This trading strategy is referred to as swing trading. Customize your risk level with this strategy by simply adjusting the Bollinger Band settings to a lower standard deviation with one instead of the standard two.
MACD is typically used to reveal whether a security is overbought or oversold, which generally leads traders to adopt trading strategies that account for a coming trend reversal. A popular trading strategy that utilizes the MACD’s power is trading divergences. When you see new highs in the security’s price but not on the MACD, sell your long positions or enter short positions as this indicates momentum behind the higher prices is waning, and prices will soon adjust.
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