What indicator is best to use with Bollinger Bands?

Unfortunately, in technical analysis, nothing is for sure, and nothing can stand by its own! We have to combine several studies and chart elements to get a clearer and more accurate picture. This article will see how we can use Bollinger Bands© with MACD indicator to increase the odds for a successful trade.

Introduction

Bollinger Bands© is a widely used technical analysis indicator created in the 1980s by John Bollinger. For 40 years, it has stood the test of time, and we can apply it in several markets, including stocks, futures, and FX. Here you can find an interview with John Bollinger.

Instead of plotting 2 lines, some fix percentages above and below a moving average (as the Envelops indicator does) use the concept of standard deviation. The upper band is plotted 2 standard deviations above a simple moving average (SMA) and the lower band two standard deviations below.

As a result, Bollinger Bands© are versatile, reacting quickly to large moves and show whether prices are high or low relative to normal trading ranges. Mr. Bollinger suggests a 20-bar SMA with +/- two standard deviations for analyzing the intermediate trend, a 10 bar SMA with +/- one and a half standard deviation for short-term trend analysis, a 50-bar SMA with +/- two standard deviations for analyzing the longer-term trend. Of course, these are not hard and fast rules, and the reader is encouraged to test other parameters more suitable for his or her trading style and time frame. You can also use an Exponential Bollinger Bands.

Digging a little deeper

Infobox – The calculation of Bollinger Bands© is rather complicated, however, most of the charting software packages, have it pre-installed. Middle Band = (by default) a 20 bar Simple Moving Average. Upper Band = Middle band + (20-bar standard deviation of price) *2 Lower Band = Middle band – (20-bar standard deviation of price) *2  

At its core, Bollinger Bands© is a volatility indicator and like an ATR Indicator, it measures historical volatility. The bands will expand or contract according to realized volatility, irrespective of the underlying trend. If the market is in a consolidation phase, having discounted most of the available information, volatility will be low, and the upper and lower bands will converge. When new information hits the wire, volatility will rise as traders fight for the new equilibrium, and the bandwidth will increase.

Many traders make a common mistake by applying the Bands for absolute buy and sell signals when the price closes or touches the upper/lower band. We should always keep in mind that Bollinger Bands© provides a framework within which price can be related to other independent studies such as volume or trend indicators.

Entering MACD in the mix

Another classical indicator that has stood the test of time is Moving Average Convergence-Divergence, commonly known as MACD, developed in the 1960s by Gerald Appel. By subtracting a slower moving average from a faster one and smoothing the result with a (usually) 9-bar moving average, this indicator can be applied both as a trend filter and a momentum oscillator.  

MACD is used in 4 different ways:

  1. As a trend filter. When positive, the trend is considered upward and when negative, downward.
  2. Crosses of MACD vs its signal line can give us buy and sell signals.
  3. It can indicate overbought or oversold levels if its price has reached extreme values.
  4. It can give us an early warning of a possible trend change, by forming divergences bullish or bearish vs price.
bullish or bearish divergence of price vs the indicator
A bullish or bearish divergence of price vs the indicator, is one of the strongest signals in technical analysis. The more divergences are developing, the stronger the set up.

Putting them together 

After this brief presentation of Bollinger Bands© (BB) and MACD, let us see how we can combine them and enhance our analysis.   

MACD is positive indicating that the trend is up. Price closed above upper BB consolidation
MACD (15,30,9) is positive indicating that the trend is up. When price closed above the upper BB (15,2,2) after a short period of consolidation, this uptrend resumed. MACD crossed from below its signal line, indicating that we should either be long or staying at the sidelines. Not short!

As we said earlier, when the market is consolidating, the upper and lower BB will converge. A close above/below the upper/lower band will signal that buyers/sellers reappeared and have the upper hand.

If MACD is already positive & rising/negative & falling, and its price is not extreme, the previous trend will continue, and it is a good point to consider adding to our long/short position.

When a market top/bottom is nearby, volatility usually increases. That is because there is a lot of optimism/pessimism and those who have lost the move are eager to enter the market for fear of missing out (FOMO) on the party! BB is extensive at this stage, and the price either closes above/below the upper/lower band or tags them continuously.

If MACD has also reached extreme levels, the move is unsustainable, and a correction, if not a reversal, is imminent. At this stage, we should avoid any new long/short positions, and in case of an open position, stops should be tight.

In our opinion, the most powerful signal of MACD is a bullish or bearish divergence vs. price. If prices are making new highs/lows, but MACD fails to do so, a market top/bottom is usually forming. In such a case, a close below/above the lower/upper band will signal that sellers/buyers are now in charge and that the uptrend/downtrend is over.

If this is the technical picture, any long/short positions should be closed and wait for confirmation that a new trend has started.

extreme widening BB and MACD were warning signals correction imminent.
EURJPY daily. a. When MACD (15,30,9) made a new 52 week high, EURJPY closed above the upper band of BB (15,2,2). Both the extreme widening of the bands and the extreme price of MACD were warning signals that a correction was imminent. b. After 2 weeks, the uptrend resumed. However, a bearish divergence had already been formed. Although the price closed above the upper BB and bands were expanding, a trend reversal was imminent.

Adding a quantitative touch in our approach

When talking about BB and how we can combine it with MACD, we used words such as expand, converge, wide and narrow. However, human eyes can play tricks with us, and what we classify as wide or big may seem to someone else as normal or small. More importantly, if we want to create a fully automated trading system, every aspect must have a number and be easily quantifiable (i.e., translated into code).

There are two indicators, Bollinger %B and Bollinger Band Width, that derive from the original Bollinger Bands©   and which quantify what narrow or wide is.

Bollinger %B, was developed as a price-momentum oscillator and similar to Stochastic, quantifies closing price, but relative to Bollinger Bands©.

  • Bollinger %B < 0 à price is below the lower band.
  • Bollinger %B = 0 à price is exactly at the lower band.
  • Bollinger %B = 50 à price is exactly at the moving average.
  • Bollinger %B = 100 à price is exactly at the upper band.
  • Bollinger %B > 0 à price is above the upper band.

Bollinger Band Width, quantifies volatility, allowing us to put a number on what low, narrow, wide or high is. It is calculated as (Upper BB – Lower BB)/Moving Average and before we can use it, we must define the relative levels.

Since this article’s scope is what indicator to use with Bollinger Bands©, we will not elaborate any further. Still, we encourage the reader to research these two indicators.

Some final thoughts

Of course, MACD is not the only indicator which can be used with Bollinger Bands©. Volume studies and money flow data are a good option too. What we should keep in mind, is to use indicators that are independent to each other and add something new to our analysis. Presenting volatility with 2 or 3 different ways will not add significant value to our approach.

Selected Bibliography

Bollinger on Bollinger Bands, by John Bollinger

The Encyclopedia of Technical Market Indicators, by Robert Colby

Technical Analysis: Power Tools for The Active Investors, by Gerald Appel