Bollinger Bands differ from the Moving Average in that it is commonly (but not exclusively) used as a signal of impending reversal, while the MA is used as a signal of continuing trends. In this sense BBs have more in common with DVaR strategies in attempting to pre-empt large reversals that can do severe damage to a trend-follower.
Some background reading here, and here.
A theoretical discussion on reversal indicators
As the empirical evidence for trend following is well established, any speculator attempting to take on a reversal position is putting himself at a relatively high probability of small loss by going countertrend. His expectation can only be brought into the black by a corresponding high payoff when the reversal does indeed happen. Since the general expectation for a long-only trend following strategy is positive, it follows that a countertrend strategy that adopts precisely the inverse of the original strategy will be lossmaking. Thus it is mathematically necessary that, for a given moving average window, a reversal strategy must be more selective than the inverse of the trend following strategy in order to have any hope of being profitable in the long run.
Bollinger Bands
Bollinger Bands achieve this required selectivity by only taking pricepoints outside a 2 standard deviation range from the average as trading signals, thus eliminating close to 95% of pricepoints. However there is no one agreed upon or systematically consistent way of using the BBs for trade entry, as John Bollinger himself concedes. There is even less of a consensus on using BBs for trade exits (Investopedia conveniently neglects to discuss this).
Testing
What’s a tester to do? I built a generalized bollinger band trading program that allows for a few options:
Exit Strategy 1 – Reversion to 1 SD
In this strategy, the “normal” buy signal is triggered when the price goes below the lower BB, which is 2 S.D. from the middle band, and the position is held until the price returns between 1.S.D and the middle band.
Without inversion, long-only
This graph shows the equity lines for long-only trades without “inverting” the normal buy and sell signals. The other charts for short-only trades and long-and-short trades show the same deal. Thus, this strategy consistently loses money on both the long and short sides. It stands to reason that “inverting” the buy and sell signals would make some dough, and so it does:
With inversion, long-and-short
This chart, unlike the first, shows the equity line from the long-and-short trades, not just the long-only: we see that it benefited on the long side during the 1997 Asian Financial Crisis (time period ~2000) and on the short side during the 2008 Global Financial Crisis (time period ~4500). This indicates that Bollinger Bands actually have better value as a trend following indicator than as a reversal indicator.
Exit Strategy 2 – “Hold to extremes”
This strategy buys when the price drops below the lower band and hangs on for dear life, selling only when the price rises higher than the upper band. Thus this strategy is much more involved in the market than strategy 1; we anticipate, from our theoretical discussion above, that strategy 2 will result in lower profits because of the “drag” from trading countertrend.
Without inversion, long-only
Without “inversion”, this strategy performs in much the same way. Same for the short-only side. Not much to report.
With inversion, long-and-short
With Inversion, the strategies work beautifully. the only task left is to compare the best of these strategies (it is the 25 -day window for the both of them).
We see that my original intuition was wrong – the CAGR for the Exit 2 strategy was actually higher. This could be because that the Exit 2 strategy actually winds up benefiting more from the trend strategy than I suspected. However, it suffers much worse and longer drawdowns than the Exit 1 strategy.
Cutting to the chase:
Bollinger Band strategies are useful as “trend-following-plus” strategies, not as “reversal” strategies.
Some background reading here, and here.
A theoretical discussion on reversal indicators
As the empirical evidence for trend following is well established, any speculator attempting to take on a reversal position is putting himself at a relatively high probability of small loss by going countertrend. His expectation can only be brought into the black by a corresponding high payoff when the reversal does indeed happen. Since the general expectation for a long-only trend following strategy is positive, it follows that a countertrend strategy that adopts precisely the inverse of the original strategy will be lossmaking. Thus it is mathematically necessary that, for a given moving average window, a reversal strategy must be more selective than the inverse of the trend following strategy in order to have any hope of being profitable in the long run.
Bollinger Bands
Bollinger Bands achieve this required selectivity by only taking pricepoints outside a 2 standard deviation range from the average as trading signals, thus eliminating close to 95% of pricepoints. However there is no one agreed upon or systematically consistent way of using the BBs for trade entry, as John Bollinger himself concedes. There is even less of a consensus on using BBs for trade exits (Investopedia conveniently neglects to discuss this).
Testing
What’s a tester to do? I built a generalized bollinger band trading program that allows for a few options:
- Varying the sizes of the moving windows
- Inverting the “normal” buy and sell signals
- Trading long-only or short-only or both
- 2 kinds of exit strategies – “reversion to 1 S.D.” and “hold to extremes”
Exit Strategy 1 – Reversion to 1 SD
In this strategy, the “normal” buy signal is triggered when the price goes below the lower BB, which is 2 S.D. from the middle band, and the position is held until the price returns between 1.S.D and the middle band.
Without inversion, long-only
This graph shows the equity lines for long-only trades without “inverting” the normal buy and sell signals. The other charts for short-only trades and long-and-short trades show the same deal. Thus, this strategy consistently loses money on both the long and short sides. It stands to reason that “inverting” the buy and sell signals would make some dough, and so it does:With inversion, long-and-short
This chart, unlike the first, shows the equity line from the long-and-short trades, not just the long-only: we see that it benefited on the long side during the 1997 Asian Financial Crisis (time period ~2000) and on the short side during the 2008 Global Financial Crisis (time period ~4500). This indicates that Bollinger Bands actually have better value as a trend following indicator than as a reversal indicator.Exit Strategy 2 – “Hold to extremes”
This strategy buys when the price drops below the lower band and hangs on for dear life, selling only when the price rises higher than the upper band. Thus this strategy is much more involved in the market than strategy 1; we anticipate, from our theoretical discussion above, that strategy 2 will result in lower profits because of the “drag” from trading countertrend.
Without inversion, long-only
Without “inversion”, this strategy performs in much the same way. Same for the short-only side. Not much to report.With inversion, long-and-short
With Inversion, the strategies work beautifully. the only task left is to compare the best of these strategies (it is the 25 -day window for the both of them).
We see that my original intuition was wrong – the CAGR for the Exit 2 strategy was actually higher. This could be because that the Exit 2 strategy actually winds up benefiting more from the trend strategy than I suspected. However, it suffers much worse and longer drawdowns than the Exit 1 strategy.Cutting to the chase:
Bollinger Band strategies are useful as “trend-following-plus” strategies, not as “reversal” strategies.
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