Content of the material
- Combining Bollinger Bands and Bollinger Bands Width
- Applying the VWAP
- Final Word
- Spotting Trend Reversals with Bollinger Bands
- Key Take Away
- Other useful resources
- Related Posts:
- VWAP Standard Deviation Bands
- Which Strategy Works Best?
- Strategy #5 – Snap Back to the Middle of the Band
- Strategy #6 – Trade Inside the Bands
- Strategy Profile Matrix
- VWAP an institutional trading strategy?
- VWAP Trading: How to Use It
The Volume-Weighted Average Price (VWAP) is calculated using the following formula:
where sizei is the volume traded at pricei.
The VWAP plot is accompanied with two bands serving as overbought and oversold levels. The Upper band (overbought level) is plotted a specified number of standard deviations above the VWAP, and the Lower band (oversold level) is plotted similarly below the VWAP. Standard deviations are based upon the difference between the price and VWAP.
Combining Bollinger Bands and Bollinger Bands Width
Pairing the Bollinger Band width indicator with Bollinger Bands is like combining the perfect red wine and filet mignon.
In the previous section, we talked about staying away from changing the settings. Well, if you think about it, your entire reasoning for changing the settings in the first place is in hopes of identifying how a security is likely to move based on its volatility.
A much easier way of doing this is to use the Bollinger Bands width. In short, the BB width indicator measures the spread of the bands compared to the moving average to gauge the volatility of a stock.
Why is this important to you?
Essentially, you have an actual reading of the volatility of a security. You can then look back over months or years to see if there are any repeatable patterns of how price reacts when it hits extremes.
To see this in action, look at the below screenshot using both the Bollinger Bands and Bollinger Band width.
Notice how the Bollinger Bands width tested the .0087 level three times. The other point of note is that on each prior test, the high of the indicator made a new high, which implied the volatility was expanding after each quiet period.
As a trader, you need to separate the idea of a low reading with the Bollinger Bands width indicator with the decrease in price. Remember, Bollinger Band width is informing you that a pending move is coming, the direction and strength are up to the market.
In this example, the 5-minute chart ofSciclone Pharmaceuticals (SCLN) had a huge runup from $9.75 to 11.12.
If you had just looked at the bands, it would be nearly impossible to know that a pending move was coming. You would have no way of knowing that .0087 was a level that existed, let alone a level that could trigger such a large price movement.
This is just another example of why it’s important to pair Bollinger Bands with other indicators and not use it as a standalone tool.
Applying the VWAP
For the reasons previously mentioned, most professional traders agree that the VWAP is influential and useful when trading in short-term timeframes. Strategies for intraday trading using the VWAP might be as simple as buying the first closing price above VWAP as an entry, and selling at a predetermined point above it. But more often than not, the strategies for trading hold a bit more complexity than that.
The reason for this is the widespread belief among professional and nonprofessional traders that enough institutional traders use the VWAP as a benchmark. Traders often believe that a recognition of this dynamic must be factored into the trading strategy.
As a result, a trader might use VWAP as a filter for their activity. They might go long only when the price is below the VWAP and short when the price is above VWAP. This filter would be based on the point of view that benchmark-beating buyers are more likely to create support when the price is below VWAP, than when it is above it. This filter would work well for days with relatively sideways price action.
By contrast, other trades might prefer the opposite tactic. They would thus assume entries for buying a stock should only occur when price is above the VWAP and short-selling entries should only be undertaken when the price is below it. This filter would be based on the point of view that benchmark watchers are unable to get the price they want and will be forced to push the stock further into its trend for the day. This filter would work well for days that had a well-defined trend for the day, whether upward or downward.
Neither tactic executed over a large number of trades appears to hold a statistical edge. Therefore traders often combine their VWAP approaches with other indications. That helps them to work with a more profitable filter depending on how they perceive the day's price action will play out.
For example, a trader can also use the VWAP in conjunction with Bollinger Bands. These are a set of trendlines plotted two standard deviations (positively and negatively) away from a simple moving average (SMA) of a security’s price that can be adjusted to user preferences. Traders may enter into a trade based on a VWAP signal and exit the trade based on a Bollinger Band signal, or vice versa.
Perhaps the most interesting use of the VWAP trade comes from programmers who have created a standard deviation of price range anchored to the VWAP. This creates price regions above and below the VWAP which make for surprisingly robust, real-time support and resistance measures (see example below).
The Bollinger bands indicator is just a tool. It has flaws and won't produce reliable signals all the time. It can help you stay on the right side of trend and spot potential reversals. For that, you'll need to set up the indicators so they align with the guidelines discussed above. Random or default setting on the indicator may not work well. Adjust the indicator, and test it out with paper trades before using the indicator for live trades.
The guidelines above are not a trading strategy on their own. A trading strategy requires entry points, exit points, and risk management, which weren't discussed in this article. Bollinger bands can be combined with a trading strategy, such as the day trading stocks in two hours method.
Spotting Trend Reversals with Bollinger Bands
Using the trend guidelines, here are the summary guidelines for spotting reversals.
- If the price is in an uptrend, and continually hitting the upper band (and not the lower band), when the price hits the lower band it could signal that a reversal has commenced. If the price rallies again, it likely won't be able to reach the upper band or the recent price high.
- If the price is in a downtrend and continually hitting the lower band (and not the upper band), when the price hits the upper band it could signal that a reversal has commenced. If the price declines again, it likely won't be able to reach the lower band or the recent price low.
Key Take Away
In conclusion, it is important to note that Bollinger Bands are just one part of trading. A trader needs to put into consideration a number of issues such as the overall market environment.
It is also prudent for one to use a combination of indicators when making an investment decision.
Other useful resources
- Bollinger Bands – Official Site
- Day Trading Strategies: 7+ Timeless Approach That Work
- The 6 Best Entry and Exit Indicators for Day Traders
- Strategies to Develop a Mechanical Trading System
- How to Start Day Trading (Figuring out if It’s Right for…
VWAP Standard Deviation Bands
As I already mentioned, using any mean-reverting strategy such as Bollinger Bands, Keltner Channels, or VWAP Standard Deviation Bands can be risky business.
If you will try to mean revert everything, it only takes one trend day and you can cause huge damage to your account.
That being said, there is a great use with these VWAP bands.
Not only for mean reversion but also trend following as we can latch into the move using 1 or 2 standard deviations of VWAP.
As you can see in the picture above, the grey shaded area represents 1 standard deviation of VWAP, and the line above/below shows 2 standard deviations of VWAP.
On strong trending moves, the price oftentimes does not pull back all the way to VWAP therefore we can latch to the move using the 1 std. deviation band.
Once price accepts back inside that one standard deviation range, we can take a trade targeting VWAP or the other side of the band.
Although mean reverting back to VWAP can work well, using VWAP in a trend following fashion is oftentimes the easier trade as all you need is breakout and retest.
When I mean revert back into VWAP, I tend to be much more careful and look for many more factors of confluence compared to simple break and VWAP retest.
Which Strategy Works Best?
This is the important question for anyone reading this article. But it is such a tough question to answer.
To that end, I’ll offer my own personal experiences. For me, there are two strategies that I prefer to use – 5 and 6.
This doesn’t mean the others might not work well for you. But we all have different personalities and trading styles.
Both of these work well, but in two very different types of markets.
Strategy #5 – Snap Back to the Middle of the Band
This Strategy will work in very strong markets. It affords you the flexibility of jumping on a hot stock while lowering your risk as you wait for the pullback.
I have been a breakout trader for years. But I will be the first to tell you that most breakouts fail. Not to say pullbacks are without their issues, but you can at least minimize your risk by not buying at the top.
Strategy #6 – Trade Inside the Bands
This approach will work well in sideways markets and will also have a high winning percentage.
How do I know it has a high winning percentage?
Because you are not asking much from the market in terms of price movement. From my personal experience of placing thousands of trades, the more profit you search for in the market, the less likely you will be right.
Now, while strategies 5 and 6 work best for me, what say you?
Since trading is a personal journey, we’ve created this strategy/profile matrix to help you uncover which might work best for you.
Strategy Profile Matrix
- Strategy #1 Double Bottom – for the pure technician. The trader that is going to scan the entire market looking for a particular setup. It will require a lot of patience to identify the setup since you need the second bottom to breach the bands to generate a powerful buy signal.
- Strategy #2 Reversals – calling all risk takers! This approach is fantastic when you get it right because the reversal will pour money into your account. However, get things wrong, and the pain can often leave you paralyzed from taking any action. You must be quick on your toes and willing to cut a loser without blinking.
- Strategy #3 Riding the Bands – for the home run hitters. You must have the sheer will to only average a 20% to 30% win ratio because you will make all of your money on the big moves. That sounds easy, doesn’t it? Well, I have tried systems that have low win percentages, and I have failed every time. This is because I am a sore loser. Therefore, I can’t handle being wrong that infrequently. So, if you want to take less action and can seriously handle being wrong eight out of ten times, this system will be perfect for you.
- Strategy #4 The Squeeze – this is the best setup for the traders that want the profit potential of riding the bands but can take quick money as things go in your favor. You can take one of two approaches with the squeeze strategy. For the riskier traders, you can jump in before the break and capture all of the gains. More conservative traders can wait for the break and then look for a pullback setup in the direction of the primary trend.
- Strategy #5 Playing the Moving Average – this is for the dip buyers. You are looking for stocks that are trending strongly and then react back to the 20-period moving average. This setup works lovely when day trading the Nikkei and usually develops a little after forty-five minutes into the session.
- Strategy #6 Trading the Range – for the edge traders. For me, it comes down to the simple fact markets are range bound 80% of the time. So, if you need thrills, this strategy will put you to sleep. You will likely want to focus on #2, #3, or #4.
VWAP an institutional trading strategy?
If you have ever seen any youtube video or read an article about VWAP, one of the first sentences is that VWAP is used by large players in the market and how you must use it as well.
Like the ClayTrader in his video modestly called Why I Started Using This Day Trading Indicator (the best!).
In the video which has over 500,000 views, he pretty describes VWAP as a tool used by portfolio managers and how they see a VWAP as a fair value.
Therefore when the price is below VWAP, they buy the underlying asset and when the price is above VWAP, they sell the underlying asset so they get more favorable prices for their clients.
Coming into the market with this mindset, all you need is one trend day to blow your account.
Although mean reverting with VWAP can work, it should never be used as a standalone strategy.
Because of the “Institutional” indicator, you will find a lot of other videos with quite a lot of views about VWAP.
Some will tell you to fade moves into VWAP and some will use VWAP as a trend indicator for continuation once price breaks above/below VWAP.
Before I show you the way how to use both, let’s cover the topic of large players trading with the VWAP.
Although it is true and you can find plenty of resources of VWAP being used by large traders and also algorithms.
You can never know how these people and bots use VWAP in decision making.
Therefore, it is completely useless to make some huge assumptions based on VWAP and justify our trading decision with this whole “institution trading approach”, simply because you never know what someone on the other side of the screen about to do.
With that being said, VWAP is a valuable tool and when used properly, it can bring great results.
VWAP Trading: How to Use It
Stocks typically go through periods of trends or consolidations. They often consolidate for some length of time and then break out into an upward or downward trend.
One way to understand the VWAP is to observe price action as it approaches a significant line on the chart. In figure 1, you see that prior to the open, there’s a price consolidation. VWAP is relatively flat, or low momentum. When the markets opened, momentum increased and, in this case, price moved below VWAP and approached the lower band but didn’t quite reach that lower band. Price moved back up, broke above VWAP, and reached the upper band, which acted as a strong resistance level. See how the price bar broke above the upper band and then quickly retraced back toward VWAP? It stayed there for a couple of bars, i.e., the support level, but then broke below it and moved toward the lower band.
This time, it reached the lower band, went below it, and then started moving back up. After a few bars, it tested the lower band again. It then moved back up toward VWAP and sort of settled there for a little while. This suggests momentum could be slowing down.
In afternoon trading, prices started moving back down toward the lower band and hung out there for a while. The lower band acted as a support level and VWAP as a resistance level.
It doesn’t have to always be this way. Sometimes, VWAP may be the support level and the upper band the resistance level—it all depends on the market action.