Bollinger Bands and Stochastic Strategy – Eliminate False Breakouts Signals

Combining two popular indicators, we have the Bollinger Bands and Stochastic Strategy. The reason why Bollinger Bands is such a popular indicator is not just because it gives you a real sense of price action, direction or where the trend is going, but more because it’s an indicator that it really works quite well unlike other indicators. We don’t need to get into the technical aspects of the formula because it’s not that important, it’s how you use this indicator that is important. The Bollinger Bands indicator it helps you identify overbought and oversold points in the market. The Bollinger Bands provide the aims to achieve your trading goals because it provides us with setups where the risk is small versus the potential gains and the odds are in our favor.

Volatility is what drives the Bollinger Bands and the most common measurement of volatility is to use the standard deviation which is very sensitive to large changes in price. The reason why we use standard deviation as our volatility measure is because when the price starts to move away from areas that have been trading at it’s the most adaptive to this rapid change in prices.

The Bollinger Bands and Stochastic Strategy

Combining the Bollinger Bands indicator, which is a volatility indicator, together with the Stochastic indicator which is a momentum indicator we can find points in prices where the market is losing steam and it’s ready to reverse course. The Bollinger Bands will help you define your entry and taking profit points while the Stochastic indicator can be used to time the market.

Without further ado, let’s write down the rules behind this simple scalping strategy:

• Currency Pair: Any, but works best on USD/JPY;
• Time Frame: 5 minutes;
• Buy Signal: Wait for the lower band to be penetrated to the downside. The Stochastic indicator must be below 20, signaling oversold conditions. If the above two conditions are present in the market wait for the first 5 minute candle to close above the lower band and enter long at the close of the candle with your stop loss 5 pips below the “breakout” candle and with the take profit targeting the middle Bollinger band.
• Sell Signal: Wait for the upper band to be penetrated to the upside. The Stochastic indicator must be above 80, signaling oversold conditions. If the above two conditions are present in the market wait for the first 5 minute candle to close below the upper band and enter short at the close of the candle with your stop loss 5 pips above the “breakout” candle and with the take profit targeting the middle Bollinger band.

We’re going to use the standard default settings on both of these indicators:

Bollinger Bands settings:

1. Period = 20 Day Exponential Moving Averages;
2. Deviation = 2 Standard Deviation;

Stochastic settings:

1. %K = 5;
2. %D = 3;
3. 14 MA period;

In the above example, we can see that combining the Bollinger Band indicator with the Stochastic we’re going to eliminate a lot of the false breakout signals as we’re only going to enter a trade only after the price has returned back inside the channel created by the Bollinger Bands indicator and if we’re in oversold/overbought conditions.

Bollinger Bands and Stochastic Strategy – Sell Setup

In the above chart, we can picture how a sell signal would look like proving the point that the majority of the cases there is a high probability that prices will reach at least the middle band if not beyond that. In other circumstance, we can target beyond the middle band and can even use the opposite band as our profit target.

The market is known to spend approximately 88% to 90% inside the bands which is a very stable quantity that makes this strategy works over time. This strategy is more suitable to the trader how has a short time horizon and scalping is something that he understand and begun to master it.