As a beginner trader, you may have been in a situation where you have many indicators on your chart without making any meaning out of them.
We have all been there — searching for the non-existent Holy Grail. And with many different indicators for analyzing and trading the markets, the search never ends.
What’s more, it seems that a new trading indicator comes on the scene every few months or thereabout to further keep you in an endless cycle.
But what you don’t know is that most new indicators are some modifications of the time-tested ones.
So, we bring to you, in this post, one of the most popular and interesting technical indicators — the Bollinger Bands.
The Bollinger Bands is one indicator that can tell you when the market is active and if it is trending or ranging.
In the post, you will learn what the Bollinger Bands is, how it is calculated, the history behind it, what it tells about the market, how to use it in your trading, and the common mistakes to avoid.
What’s Bollinger Bands?
Bollinger Bands is a tool for technical analysis that functions specifically as a price band, indicating relatively overpriced and underpriced regions of the price chart, where one can look for tradable opportunities.
A price band, also known as a trading band, is a tool that defines the high and low of the price action using a measure of central tendency, such as a moving average, as a base.
The Bollinger Bands indicator consists of a simple moving average as the centerline and two bands — one plotted 2 standard deviations above the centerline and the other plotted 2 standard deviations below the centerline.
Standard deviation is a mathematical formula for measuring variation — the degree with which a value varies from the mean.
When it comes to forex and other financial markets, the variation in price indicates volatility.
Thus, the indicator shows the mean value of the price and the degree to which the price moves above and below the mean.
The mean is measured by an n-period simple moving average and forms the centerline, while the upper and lower bands give a measure of the variation of the price from the mean (volatility).
The default setting for the Bollinger Bands is a 20-period simple moving average and 2 standard deviations each for the upper and lower bands.
However, a trader may decide to use a different setting. Some use an exponential moving average instead of a simple or a 22-period instead of 20-period, while others use 3 standard deviations. You can even create more bands with 1 or 3 standard deviations.
With the upper and lower bands of the indicator showing relatively overpriced and underpriced levels, the Bollinger Bands function like a conditional oscillator, with the price oscillating between the upper and lower bands (about the mean) when the market is moving sideways.
In such market conditions, the upper band serves as a potential overbought region, while the lower band serves as the oversold area.
However, when the market is trending, the price tends to stay around the band in the trend direction.
So, in an uptrend, the price tends to stay around or even walk through the upper band, while in a downtrend, the price tends to stay around the lower band or walk through it.
History of Bollinger Bands
Bollinger Bands indicator was created in the early 1980s by John Bollinger, a market technical analyst, trader, and teacher.
His aim was to develop a way to visualize changes in volatility, which as at then, was seen as a static parameter.
The popular trading bands then were the percentage bands, which does not adapt to changing market conditions, and Donchian bands that measure recent highs and lows. There was also the Keltner band that uses the average true range to measure price volatility.
But none of those captured changing price volatility the way Mr. Bollinger wanted it. So, he used a statistical model that measures the mean and variation.
He used an n-period simple moving average for the mean and 2 standard deviations of the moving average for the variation.
How is the Bollinger Band calculated?
The mathematical formula may look scary to someone without a mathematics or statistics background, so it is better we go with the explanation of the calculation process.
As we stated earlier, Bollinger Bands is made up of three lines — a central line, an upper band, and a lower band. By default, the centerline is a 20-period simple moving average.
To get the upper band, you add twice the daily standard deviation to the moving average value for the day.
For the lower band, you subtract two times the daily standard deviation from the moving average value for the day.
Note that the population version of standard deviation is used. Of course, these calculations are automatically done by the trading platform.
What Bollinger Bands can tell you about the market
The Bollinger Bands is a very versatile indicator that can tell you a lot of things about the market, including the level of activity in the market and the market structure.
It all depends on what you want to use it for. For the most part, the Bollinger Band can show you the following :
- Market volatility
- Ranging market
- Trending market
The Bollinger Bands indicator is one of the best tools for gauging the level of volatility in the market, which is a technical term that defines how big the price swings are and the time taken to make each swing.
Bigger and faster price swings imply a higher degree of volatility, while smaller and slower price swings mean a lesser degree of volatility.
Here is why Bollinger Bands is a good measure of volatility. Standard deviation, which is a major component in the calculation of Bollinger bands, is one of the statistical measures of variation.
In fact, the standard deviation is the most accurate measure of variation. In the financial market world, the degree of variation in price is an indication of the level of volatility in the market.
Generally, the upper band of the Bollinger indicator indicates a price level that is statistically high or expensive compared to the mean value.
On the other hand, the lower band indicates a level that is statistically low or cheap compared to the mean.
These high and low levels are expanding or contracting in accordance with the level of activity in the market.
Thus, the width of the Bollinger Bands — the distance between the upper and lower bands correlates with the volatility of the market because the standard deviation increases when the price ranges are wider than average and decreases when price ranges are narrower.
In other words, when the Bollinger bandwidth widens, it means that there is an increase in market volatility, and when the bandwidth narrows, the market is less volatile.
It should be noted that while both the upper and lower bands expand during a period of higher volatility, the side where the price is headed expands the most.
So, if the price is going upwards, the upper band expands more to accommodate the price. The opposite is true for downward price movements.
Apart from showing the degree of price displacement, Bollinger Bands can also show the structure of the market and how the price is moving.
Based on the shape and slope of the bands, you can tell whether the market is in a range or a trend.
When the market is in a range, the Bollinger Bands indicator will stay almost flat and horizontal, with little or no slope.
In such situations, the upper band would correspond to the upper boundary of the range and function as a resistance zone, while the lower band would correspond with the lower boundary of the range and act as a support zone.
The distance between the bands shows the size of the range, which is one of the factors that determine if the range is worth trading — whether there’s enough room for price movement before hitting the opposite band.
There are times when the range gets really tight — we will discuss that in a moment. Another important thing to note is that the price will eventually break out of range, and how long the range lasted may determine how well the price can move after the breakout.
If you are already good at reading price action and the overall market movement, you won’t have a problem identifying if there is a trend in the market and the direction of the trend.
However, Bollinger Bands can even make things a lot clearer if you understand how the bands move in relation to price movements.
As the Bollinger Bands tends to form a trading band around the price action, it moves with the price in whatever direction the price is headed.
Thus, if the price is trending upward, the Bollinger Bands will have an upward slope, and if the price is trending down, the Bollinger Bands will have a downward slope.
Another factor that tells the trend direction is where the price predominantly stays.
In an uptrend, the price predominantly stays around the upper band and may even walk through it, while in a downward trend, the price stays around or even walks through the lower band.
Now, here are important things to note when the market is trending.
In an uptrend, both the Bollinger centerline, which, of course, is a 20-period moving average, and the lower band, which indicates statistically cheaper price levels compared to the mean, act as rising support levels.
On the other hand, when the market is trending downwards, both the center line and the upper band, which indicates statistically high or expensive price levels compared to the mean, act as descending resistance levels.
Tight consolidation (Bollinger squeeze)
There are times when the price stays in a very tight range because of low volatility. In such situations, the price barely makes any swings — you will see more of price bars lying side by side.
When this happens, the Bollinger Bands indicator contracts. In other words, the upper and lower bands come very close to each other, and it is called the Bollinger Band squeeze.
Tight consolidations are almost always followed by explosive price movements. And the reason is simple.
Market volatility is always changing — a period of very low volatility is followed by a period of high volatility and vice versa.
So, when you spot a Bollinger Bands squeeze, get ready for an explosive breakout either up or down.
In the strategies section, we will discuss how you can identify the most likely direction of the breakout.
Strategies for trading with Bollinger Bands
Now that we have learned the most important things the Bollinger Bands indicator can tell us about the market, let’s look at how you can use the indicator to find tradable opportunities.
If you’ve been following keenly, you would’ve noticed that the indicator can be used differently in different market conditions — ranging or trending markets.
Here are some of the strategies you can trade with Bollinger Bands.
Trading the bounce
In a ranging market, you can trade price bounce at the upper and lower bands because they correspond to the upper and lower boundaries of the range.
At the upper band, you can look to go short and exit the trade before the price reaches the lower band, while at the lower band, you can look for long positions to exit before the upper band.
However, the price tagging either of the bands is not an indication to enter a trade. There is a need to combine the Bollinger Bands indicator with other tools to improve the chances of a successful outcome.
When there is a confluence of several supporting factors that align in the direction of your trade, then you have a high probability setup.
One of the tools you need to use is the support and resistance levels. The upper boundary of the range must have established some level of resistance — there must have been at least one price swing that reversed around that level.
Similarly, the lower boundary must be a support level — the price must have reversed around that level before.
When you have established the presence of support and resistance levels at the lower and upper bands of the Bollinger indicator, you can then look for the corresponding trade triggers at those levels — bullish trade triggers at the lower bands and bearish trade triggers at the upper bands.
Your trade trigger can be an oscillator divergence signal or a reversal candlestick pattern, such as a pin bar, inside bar, or engulfing bar.
At the lower band, look for a bullish reversal candlestick pattern or a bullish divergence in the RSI or stochastic.
When the price is around the upper band, look for a bearish reversal candlestick pattern or a bearish divergence in the RSI or stochastic.
Bollinger Bands squeeze breakout
As you have seen above, there are periods of very low volatility in the market when the price forms tight consolidations, causing the upper and lower bands of the Bollinger indicator to come very close to each other — a Bollinger Bands squeeze.
Since the price changes from a period of low volatility to a period of higher volatility, it is expected that the price will move fiercely once it breakouts out of the tight consolidation.
Hence, Bollinger Bands’ squeeze presents a unique tradable opportunity when the price goes beyond one of the bands.
It should be noted that the longer the period of consolidation, the more explosive the breakout would be.
But then comes the big question : how do you know the direction the breakout will occur? Well, while you cannot know for sure where the breakout will occur, there are a few ways you can guess the most likely direction.
The most common one is to check the direction of the trend. More often than not, consolidations are only a pause in a trending market, and the price is likely to continue in the trend direction.
Here is how to trade Bollinger Bands squeeze when you see one :
-Check the trend direction
-Look for a price close beyond the band in that direction — if the trend is upwards, a close above the upper band, and if the trend is downward, a close below the lower band
-Place your stop loss beyond the other band
-Trail your profit or place a profit target with at least 3:1 reward/risk ratio
Another thing that can offer a clue is if there is already a false breakout in one direction in which case the real breakout is likely to be in the opposite direction.
So, when you notice a false breakout after a squeeze, prepare for a breakout in the other direction. If it occurs, it is likely to be the real deal.
Trading pullbacks in a trend
The Bollinger Bands can be used in trading a trending market because not only can it show the trend direction, but also the centerline and the bands can serve as dynamic support or resistance levels.
In an uptrend, the price usually stays around the upper band, but from time to time, it may pull back to either the centerline or the lower band, both of which act as rising support levels.
During a downtrend, the price tends to stay around the lower band, but price rallies tend to reverse around the centerline or the upper band, both of which act as descending resistance levels.
A pullback to such levels may present good trading opportunities in the direction of the trend.
However, you need to make use of trade triggers, such as reversal candlestick patterns or oscillator divergence signals.
In an uptrend, here is how to trade a pullback with Bollinger Bands :
-Confirm that there is an uptrend
-Wait for a pullback to the lower band — if the price is speeding up and the trend is very steep, a pullback to the centerline, which is often a 20-period simple moving average, is enough
-Look for a bullish candlestick setup or a bullish RSI or stochastic divergence and enter a long position when you see one
-Put a stop loss some pips below the swing low
-Place a profit target at the next resistance level or trail your profit to ride the trend
Another thing that can offer a clue is if there is already a false breakout in one direction — in which case the real breakout is likely to be in the opposite direction.
So, when you notice a false breakout after a squeeze, prepare for a breakout in the other direction. If it occurs, it is likely to be the real deal.
To trade a pullback with Bollinger Bands in a down-trending market, follow these steps:
-Be sure there is a downtrend
-Wait for the price to rally to the upper band — if the price is dropping at a faster rate and the downtrend is very steep, a rally to the centerline, which is often a 20-period simple moving average, is enough
-Now, check for a bearish candlestick setup or a bearish RSI or stochastic divergence and when you see any of them, go short
-Put a stop loss some pips above the swing high
-Place a profit target at the next support level or trail your profit to ride down the downtrend
Potential trend reversals
As Mr. Bollinger suggested in one of his articles introducing the Bollinger Bands indicator, you may be able to use the indicator to spot potential trend reversal levels when you combine it with some reversal chart patterns, especially the double bottom or double top chart pattern.
In this case, the indicator helps you to confirm a shift in price momentum when the second bottom or top is formed.
Here’s the thing, in a double bottom (W pattern) or double top (M pattern), the price reverses at the same level twice.
The second one is more like a retest of that level after the initial reversal.
During this retest, the Bollinger Bands indicator may help you gauge the momentum with which the price is retesting that level.
If the retest price bar remains within the Bollinger Bands, then, momentum is shifting in the opposite direction, and a trend reversal likely.
This may help you make an earlier entry than the usual neckline breakout used for trading double bottoms/tops.
Here is how you can do use the Bollinger Bands to spot a trend reversal trade:
-Note the price level where the first reversal occurred
-Wait for the price to retest that level
-Check if the retest bar is lying within the corresponding band
-You may enter a trade at the close of the next positive bar and manage the trade accordingly with stop loss and trailing stop
Mistakes to avoid
Here are some common mistakes to avoid when trading with Bollinger Bands:
Using only the Bollinger Bands indicator: The Bollinger Bands indicator is exactly that, an indicator.
It isbollinger-bands-iwthmeant to be used as one of the tools in your toolbox and not the only tool.
You should use it along with other tools like support and resistance levels and trend lines.
Not knowing how to trade different market conditions: Bollinger Bands can be used differently in different market conditions.
While you can profitably trade price bounces at the upper and lower bands in a ranging market, trading it against a trending market is calling for a disaster as the price can walk through the band for a prolonged period when there is a trend.
Not making use of trade triggers: Trade triggers help you refine your entry point. They tell you the right time to enter a trade after identifying a tradable opportunity.
Using a tight stop loss: It is good to give your trades enough room so that price gyrations don’t knock off your trades before the price moves.
Bollinger Bands is a simple technical tool that has a centerline with an upper and lower band.
The bands can tell the relative highness and lowness of the price, as well as changes in market volatility.
Some of the strategies to trade with the indicator include pullback reversals, trend reversal, band bounces, and consolidation breakouts.