7.4 How to Trade DBB Rule 3: Identify Momentum Weakness

Additional Reading About DDBS 4 Rules, Rule 3

Rule #3 of the Double Bollinger Band Trading System posits that one should not trade based on Double Bollinger Band indicators when the price is between the buy and sell zones.

What this means is that when the price is in the middle zone of the 1 standard deviation Bollinger Bands, the trend isn’t strong enough to depend on. In this case, it would not be prudent to trade unless there is enough other fundamental evidence or signals from your other technical indicators that suggest the trend will continue.

There are times when one should ignore rule 3 and other times when it is necessary to find that balance between using too little evidence to see the full picture and using so much that it causes paralysis and prevents one from taking action.

However, rule 3 may often work well in keeping the trader out of a choppy situation where it is harder to trade profitably when there is no clear trend as indicated by the Double Bollinger Bands.

Instructor's Notes

In this lesson's video, it is stated that, unless trades are meant to be kept open for no more than a few hours at most, fundamental analysis should always be taken into account in executing trades.

It is important to emphasise that while good fundamental analysis can usually enhance longer-term trading, it is by no means an essential part of trading profitably on any time-frame. It is perfectly possible to be profitable with technical analysis alone. Nevertheless, most of the world's most profitable traders would tend to agree that a good ability to combine the two methods leads to the best results.

The video focuses on Rule #3: exit any trend trades, and consider range trading strategies, when the price has made a sustained move into the neutral zone.

Some further advice:

• Don't enter or exit a trade based on just one technical indicator alone
• Technical signals can be more easily interpreted with greater trading experience
• Don't rely on technical analysis only (see the earlier comments)

DBBS 4 Rules Rule 3 - Text Version

How to Use Bollinger Bands

When price is in the middle area bounded by the one standard deviation Bollinger Bands, (aka the DBB neutral zone), that’s your signal to exit any trades that are riding the current up or down trend, because that trend is showing weakness. There isn’t enough up or down momentum for us to have confidence in the uptrend or downtrend.

Bollinger Bands Strategy

In other words, when price makes a sustained move into the neutral zone, that’s a signal to:

• Exit trend based trades
• Consider range-trading strategies. That is, entering long positions at the bottom of the trading range, closing them as price reaches the upper end of that range, and then opening short positions to ride the move back to the lower end of the trading range.

For example, see Fig 8.6 above and focus on the area bounded by the arrows on
the right and the left.

The Double Bollinger Bands neutral zone is bounded by the red Bollinger bands, which are one standard deviation away from the purple 20 week simple moving average that forms the baseline for both sets of Bollinger bands.

During this period, the index spent most of its time within this middle, neutral zone that signals a lack of trend strength. Shorter term range traders might try to trade the range. Those who prefer to trade strong trends would have saved themselves time and money by avoiding trading.

However, Figure 8.6 is a great illustration of 3 key points:

Point 1: Don’t trade based on signals from just one technical indicator like DBBs

Note that for much of the period, the index was in the sell zone, bounded by the lower red and yellow Bollinger bands. Per rule 1 above, that means we should have been short the index.

The problem is that price kept chopping up and down in a narrow range, and after a few candles would jump back and forth between the lower sell zone and middle neutral zone. Unless you were trading on a much shorter time frame, making money by betting on a downtrend would have been challenging and risky.

That’s why we use additional technical indicators, and also pay attention to the fundamentals, like news events, that so often drive these price moves shown on the charts.

Point 2: You improve at interpreting technical signals with experience

Here’s a classic case of how rules like these are not immutable, but rather are helpful guidelines that you’ll become better at applying as you gain experience.

An experienced trader would know that when volatility drops and price trades in a narrow range, Bollinger bands reflect that reduced volatility and the distance between them narrows. That reduced distance from one zone to the next is a signal that:

• Price movements between the DBB zones are less meaningful, weaker signals because little price change is needed to make those moves. Any moves to different DBB zones should be viewed with more skepticism than in times of wider trading ranges and greater distance between the different DBB zones.
• There is no strong momentum and thus no reliable trend.

Thus when you first start using DBBs or other popular indicators, don’t be quick to condemn them if they don’t work for you. The problem might be with your own lack of experience.

Point 3: Don’t rely on technical analysis only

Unless you’re trading very short term movements and don’t plan on holding a position for more than a matter of minutes or hours, you need to pay attention to fundamental analysis, like the key headlines that are driving markets.  

For example, note how in Figure 8.6 above the first 10 candles were in the DBB buy zone. Per rule 2, we should have been long the index. However the Spring and Summer of 2010 were when the first (of what would become a series) of Greek debt crisis hit markets, and there were legitimate concerns of another financial crisis on a magnitude of that which hit in late 2008 to early 2009, when the global banking system itself appeared unstable. Given that threat, risk-averse traders might have considered exiting some or all of their long risk asset positions even before the index began to dive.