Using Bollinger Bands to Indentify Parabolic Moves - Breakouts and Breakdowns

Click on Chart to Enlarge

The chart above is Bank of America, ticker BAC. The previous post highlighted AIG and this one is similar, but had at least one set-up that was more obvious that I wanted to highlight. So first off I will highlight the main concept of what to look for in bollinger bands to identify good parabolic trading opportunities. You may be able to program some scan software to find these set-ups, but mainly you should have watchlists that you check basically every day and get to know a stock or 2 in every main sector and also have some idea of the fundamental outlook for certain industries to know ahead of time what stocks will likely lead or lag the market up or down.

1) Identify a range bound period in the stock. The bollinger bands will both point sideways and form a horizontal channel. This will coincide will declining volatility which is an added benefit if buying long call or put options.

2) Identify price then move and CLOSE above the upper band or below the lower band at least 2 and probably even 3 days in a short period of time. The two bollinger bands should be expanding (top band going up and the bottom band going down) during this period.

3) Price should basically stay above or below the 20 period moving average (in the direction of your trade), and then eventually the upper band will curl down if dealing with a bearish breakdown or the lower band will curl up after a bullish breakout. At this point the bands will be roughly parallel and form a channel that slopes up or down in the direction of your trade.

4) After an uptrend, eventually the upper bollinger band will flatten or curl down. After a downtrend, the lower band will flatten or curl up. This indicates that the parabolic move is probably over or at least weakening. This would be the simplest pure exit signal using the bands themselves as the indicator.

Basically all price movement will fall into one of the above stages of bollinger band activity and can be useful in reading a chart.

As far as the chart above, I have indicated two bearish breakouts and one bullish breakout using red and green diverging trendlines respectively. I have indicated 2 clear horizontal channels with pink lines which should be an alert to watch for a breakout. One subtlety is that before a true breakout there will often be a false breakout in the other direction. So before a bearish breakdown, price will usually move toward the upper band and may even close a day above it. However, weak volume, a reversal candlestick, or bollinger bands not diverging will be clues not to trust that move.

There is a near perfect example of this indicated on the chart in mid-October. A shooting star formed on modest volume at the upper band and then reversed off the upper band to now form a nice looking bearish break last week. The failed breakout would be the ideal time to enter a trade in the opposite direction, assuming you get good at recognizing them. Study of market sentiment, indicators, and chart patterns should help in that regard. The stop point in that case is simple - a penny above or below the reversal candlestick. You could possibly choose to wait to see a close above or below the reversal candlestick as a stop out signal if you are disciplined to exit at that point or have it programmed into a trading system. That could avoid a few whipsaws but is certainly not necessary to still get many good trades.

So how do you manage a trade on a break out? Here are some guidelines.

1) Enter the trade at the end of the day (or on the open the following day) of the 2nd or 3rd close outside the band

2) Immediately set a stop loss above/below the most recent swing high on the chart. That defines your initial risk. As an alternate, when the breakout occurs with a very large candlestick and heavy volume, you can place your stop a penny below/above the low/high of that candlestick. I would do this if such a candle exists, particularly if the most recent swing high/low is quite a bit away making the likely risk to reward ratio less than fantastic.

3) As price moves in the direction of your trade, modify the stop order to a penny above or below the most recent swing high/low. In waterfall declines with no swing highs/lows using the Parabolic SAR indicator will be a good choice to objectively move the stop.

4) The exit is certainly the most difficult part to do consistently well for the typical retail trader. Everything is straight forward on the entry, but now that you have money at stake, the emotions come into play of fearing the trade going against you or hoping that it goes your way forever (greed). If you do everything up to this point so far, you will be in good shape and almost certainly profitable. If you can simply look at the chart and forget about everything else the rest will come along as well.

- Using the BAC chart above, we have identified a bearish breakdown. Assuming the trend continues for a while, there will come a point when it ends. The lower bollinger band will then curl up. This may be a day or more after the low, and price may be strongly rebounding already. That's OK. Price is confirming the reversal that it's time to get out. So staying with the bands as the primary indicator on BAC, the curl up in the lower band is the exit signal. Plain and simple - regardless of how far it is up from the bottom tick already at that point.

- If you are a good at candlestick analysis, then you will often see a candlestick reversal which is classic and can exit immediately (at the close or on the open the next day) without waiting for the band to curl up. In my experience, the bottoming candlesticks will be easier to identify because volatility will be higher fear is a stronger and shorter lived emotion than the complacency at the end of up trends.

Another assuming you stay in a trade and haven't exited via one of the other methods, there is another subtlety of the bollinger bands which many people don't typically look at. You can use the bands to identify divergences like with oscillators. So if price consolidates and then makes a new low, but the lower band does not make a new low, that would be like a bullish divergence adding to the evidence that your exit will be soon at hand. A good example of this can be seen comparing the February and March low on the chart above.


This chart shows BAC with a parabolic SAR overlaid. If you look at the breakouts shown in the prior chart, then you can see how the SAR level can be used as a trailing stop level to exit the trade. So it can be used as a completely objective way to manage the trade and is designed for parabolic moves.