Using Bollinger Bands in a Mean Reversion Strategy

This lesson turns to Bollinger Bands — another useful tool for building out your mean reversion approach to trading Volatility Indices. Bollinger Bands give traders a clearer read on price trends and potential turning points.

What Bollinger Bands Are Made Of

Bollinger Bands are built from three lines that together map out price behaviour:

Middle Band: The 20-day Moving Average of price, showing the average over the past 20 days. This is the baseline everything else is measured against.

Upper Band: Sitting above the middle band, this line is calculated by adding two standard deviations to the Moving Average — marking a plausible upper limit for price movement.

Lower Band: Sitting below the middle band, calculated by subtracting two standard deviations — marking a plausible lower limit for price movement.

Standard deviation measures how far price has drifted from its average, which is what lets traders spot when a price level looks unusually high or low relative to recent history.

Adjusting Bollinger Bands to Fit Your Style

A couple of settings let you tailor Bollinger Bands to how you trade:

Changing the Moving Average period: Shortening or lengthening the period changes how sensitive the bands are to price movement.

Adjusting the standard deviation: Widening or narrowing the number of standard deviations changes how wide the bands are, which in turn changes how often you get a trading signal.

Bollinger Bands and Mean Reversion

Given how much Volatility Indices tend to move, they're well suited to Bollinger Bands — regular swings and range-bound behaviour are exactly the conditions this tool is built to work with.

Spotting Entry and Exit Points

Traders generally look for opportunities when price touches one of the outer bands:

Long position example: If the Volatility 50 Index touches the lower Bollinger Band at $247.50, a trader might consider going long, on the expectation that price will drift back toward the middle band. A natural exit or take-profit point in that case is the middle band itself.

Short position example: If price touches the upper Bollinger Band around $252.50, a trader might go short instead, expecting a pullback toward the middle band.

Setting Stop-Loss and Take-Profit Levels

Traders with a higher risk tolerance sometimes aim further, targeting the opposite band:

For long positions: Place your stop-loss just outside the lower band, and target either the middle or upper band for take-profit.

For short positions: Place your stop-loss just outside the upper band, and target either the middle or lower band for take-profit.

Using Bollinger Bands to Read Volatility

Bollinger Bands also double as a way to gauge how much the market is actually moving:

Band Width = (Upper Band − Lower Band) ÷ Middle Band

When the bands pull in tight, that's known as a Bollinger Band squeeze — a sign that volatility has dropped and a breakout, in either direction, may be building.

Trading the Squeeze

The squeeze itself can form the basis of a structured trade:

Price near the upper band: Consider a short position. Depending on your risk tolerance, set your take-profit at the SMA or the lower band, with a stop-loss just outside the upper band.

Price near the lower band: Consider a long position. Set your take-profit at the SMA or the upper band, with a stop-loss just outside the lower band.

Conclusion

Getting comfortable with Bollinger Bands can sharpen your mean reversion approach to trading Volatility Indices considerably. Knowing how to read entry and exit points, and how to build a strategy around shifts in volatility, gives you another solid tool for improving your trading.

In the next lesson, we'll look at putting these mean reversion strategies into practice on Deriv MT5. Stay tuned, and happy trading!