In today’s article, we are going to finally get the Bollinger Bands ® explained to you in a meaningful manner.
Bollinger Bands ® is one of the most accurate and efficient trading indicators that traders can choose from.
Typically, it is also one of the first indicators many who learn forex trading for beginners stumble upon first.
Bollinger Bands ® can be used to read the trend power, help time entries in the range markets, and to identify future market tops.
In this post, we’ll show you how to use Bollinger Bands ® to improve your chart reading skills and to recognise high likelihood trade entries.
Bollinger Bands ® Explained
A Bollinger Band ® is a technical analysis method defined by a series of patterns measuring two standard deviations (positive and negative) away from the middle line.
The middle line represents the mean price over the past 20 periods.
Bollinger Bands ® has been developed and patented by renowned professional trader John Bollinger.
The indicator is used to find assets that are trading away from their mean price, thus highlighting a high probability of reversion back to the mean (SMA line).
A forex trader uses this as an indicator when something is over-bought or over-sold, however, this isn’t always the case as you will learn later on.
As the name suggests, Bollinger Bands ® are price channels that are seen above and below the mark.
The outer Bollinger Bands ® are dependent on market volatility, which means that they expand when prices fluctuate and patterns are high, and the Bands contract during sideways consolidations and low momentum patterns.
By default, the Bollinger Bands ® are set to 2.0 Standard deviations, which ensures that 95% of all market action takes place between channels from a statistical point of view.
When the price pierces either of the Bollinger Bands ® – this highlights that there is a change in price away from the mean.
The middle of the Bollinger Bands ® is the 20-period mean average of the price and the optimal complement to the volatility-based outer bands.
Calculation of the Bollinger Bands ®
First of all, measure a simple moving average.
Then, measure the standard deviation for the same number of cycles as the simple moving average.
Connect the standard deviation to the moving average for the upper section. In the lower band, deduct the standard deviation from the moving average.
Fortunately, you don’t need to input the maths thanks to advances in technology.
You can find the Bollinger Band ® indicator on virtually every trading platform, this will plot them for you.
Typical values used for:
- Short-term: 10 day period, 1.5 standard deviation bands.
- Medium-term: 20 day period, 2 standard deviation bands.
- Long term: 60 day period, 2.5 standard deviation bands.
How to trade trends using Bollinger Bands ®
Bollinger Bands ® is not as laggy as other indicators, so they can adjust the price directly.
The key difference here is that they are plotting the MEAN movements, not the CLOSE prices.
We may use Bollinger Bands ® to assess the potential of movements and to gain a lot of useful intel in this way.
There are only a few things that you need to pay attention to when it comes to using Bollinger Bands ® to evaluate market strength:
- During strengthening/weakening markets, prices remain similar to the outer band.
- If the price shifts away from the outer band as the market moves, it shows a declining momentum.
- Repeated moves through the outer bands that don’t really hit the band to demonstrate a lack of control.
What are Bollinger Bands ® telling you?
Bollinger Bands ® is a very common technique.
Many traders assume that the more prices travel to the upper band, the more the market is oversold, and the more prices move to the lower band, the more the market is oversold.
John Bollinger provides a compilation of 22 rules to obey when using the bands as a trading system.
In the table below, Bollinger Bands ® carries the 20-day average of the market with the upper and lower bands along with the regular fluctuations of the stock price.
Since the standard deviation is a measure of instability, as stocks get more competitive, the bands expand; during less volatile times, the bands compress.
There are two key methods of trading Bollinger Bands:
Squeezing is the core principle of Bollinger Bands ®.
If the bands come tight together, constricting the moving average, it’s called a squeeze.
Squeezing shows a time of subdued uncertainty and is seen by traders as a possible indicator of increased volatility and new selling/buying opportunities in the future.
Conversely, the larger the bands widen, the more volatility is created and confidence in the market direction.
About 95% of the pricing movement is between the two channels.
Any break-out over or below the bands is a significant moment.
The breakup is not a trade warning.
The error most people make is to assume that a price that approaches or crosses one of the bands is a warning to purchase or sell.
Breakouts offer no hint as to the path and scale of potential market fluctuations.
How the Bollinger Band ® indicator works
When bands contract during a time of low volatility, the risk of a sudden price change in either direction is increased.
This could start a trending shift.
Look out for a false move in the opposite direction until the right movement starts.
As bands are separated by an extremely large amount, the variance increases and any current trend can be brought to an end.
Prices appear to move inside the band channel, hitting one band, and then switching to the other band.
You can use these fluctuations to help you define future trades.
For example, if the price bounces off the lower band and crosses above the middle line, the upper band becomes the take profit level.
Price can pierce the band envelope for long periods of time during strong trends.
A strong trend can be expected to continue as the price moves out of the bands.
However, if prices shift back within the band immediately, the proposed market strength is weakening.
After reading this article, you should have finally had the Bollinger Bands ® explained to you in great detail.
This can serve as a platform to deepen your knowledge on the subject further.
The Bollinger Bands is just an indicator.
It has defects, and it will not deliver accurate signals all the time.
However, it can help you stay on top of the trend and spot potential reversals.
In order to do this, you will need to set up indicators in order to align them with the guidelines discussed above.
The random or default setting of the indicator may not work well.
Adjust the indicator and test it with a demo account before using it on a live account.
The above guidance is not a trading strategy on its own.
A trading strategy requires entry points, exit points and risk management, which have not been discussed in this article.
The Bollinger Bands may be combined with a forex trading strategy to potentially enhance its effectiveness.