Bollinger bands are designed to give traders a feel for what the volatility is in the market and how high or low prices are relative to the recent past. The basic premise of Bollinger bands is that price should normally fall within two standard deviations (represented by the upper and lower band) of the mean which is the center line moving average. As this is the case trend reversals often occur near the upper and lower bands. As the center line is a moving average which represents the trend in the market, it will also frequently act as support or resistance.
The first way that traders use the indicator is to identify potential overbought and oversold places in the market. Although some traders will take a close outside the upper or lower bands as buy and sell signals, John Bollinger who developed the indicator recommends that this method should only be traded with the confirmation of other indicators. Outside of the fact that most traders would recommend confirming signals with more than one method, with Bollinger bands prices which stay outside or remain close to the upper or lower band can indicate a strong trend, a situation that you do not want to be trading reversals in. For this reason selling at the upper band and buying at the lower is a technique that is best served in range bound markets.
Buying and Selling at the Upper and Lower Bands
A Chart Showing the Strategy of Buying and Selling at the Bollinger Band Upper and Lower Bands
Large breakouts often occur after periods of low volatility when the bands contract. As this is the case traders will often position for a trend trade on a break of the upper or lower Bollinger band after a period of contraction or low volatility. Be careful when using this strategy as the first move is often a fake out.
Bollinger Band Contractions
As Bollinger bands paint a good picture directly on the price chart of how high or low price is relative to historical prices, this is a good indicator to use in conjunction with other methods such as some of the chart patterns that we have learned so far and some of the candlestick patterns which we will learn in future lessons.
Below is One Such Example
A Chart Showing Bollinger Bands with Multiple Confirmations
Bollinger Bands are an indicator that allows users to compare volatility and relative price levels over a period time. Using ADX with Bollinger Bands over 20 days period of time give strong signals:
Signal to buy: When the price below the lower band of Bollinger (20, 2) & DI+ over DI-, ADX line cross 20 level, ADX and DI+ rising and DI- falling. Signal to buy: When the price above the upper band of Bollinger (20, 2) & ADX line cross 20 levels and rising where DI+ falling and DI- rising.
Envelopes are formed with upper border U and lower border L. The formula is:
U = ( 1 + u / 100 ) x SMA (P, n)
L = ( 1 - d / 100 ) x SMA (P, n)
where
U � upper border;
L � lower border;
u - % above the moving average;
d - % below the moving average;
SMA (P, n) � moving average.
The percentage ("u" and "d") should be set so that about 95% of price activity is contained within the envelope and 5% outside it. The indicator will then be adequate to the market balance and all prices will come back to the envelope after they exit it.
Bollinger Bands
Bollinger Band is constructed by placing upper and lower bands around a moving average, the band width is not constant but instead proportional to the mean square divergence from the moving average over the specified period of time. Based on the Bollinger Band analysis, the decision to enter/exit the market is made when the price rises above upper BB resistance or falls below lower Bollinger Band support.
If the price moves within upper and lower bands, then Bollinger Band analysis is not a reliable method to determine when the best time to open/close positions is. Once the price penetrates the band to, then come back to the previous levels, then it is considered as the right time to open a position.
Sometimes, when the price penetrates the Bollinger Band and only "tries" new levels, but then comes back right away it may be a false breakout. If it is a true breakout then you have the possibility to trade against the trend. However, it is important to make sure that the breakout is false. In this case refer to the volume because it sharply decreases if the breakout is not false.
Bollinger Bands show the strength of the market:
Bollinger Bands contract when the market is quiet, without sharp price movements, consolidating to continue the prevailing trend or produce a new one.
Bollinger Bands widen when the prevailing trend becomes stronger or at the beginning of a new trend. A good trend confirmation is when bands widen and volume rises.
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Congratulations on making it to the 5th grade! Each time you make it to the next grade you continue to add more and more tools to your trader’s toolbox. “What’s a trader’s toolbox?” you say… Simple! Your trader’s toolbox is what you will use to “build” your trading account. The more tools (education) you have in your trader’s toolbox (YOUR BRAIN), the easier it will be for you to build.
So for this lesson, as you learn each of these indicators, think of them as a new tool that you can add to that toolbox of yours. You might not necessarily use all of these tools, but it’s always nice to have the option, right? Now, enough about tools already! Let’s get started!
Bollinger Bands
Bollinger bands are used to measure a market’s volatility. Basically, this little tool tells us whether the market is quiet or whether the market is LOUD! When the market is quiet, the bands contract; and when the market is LOUD, the bands expand. Notice on the chart below that when the price was quiet, the bands were close together, but when the price moved up, the bands spread apart.
That’s all there is to it. Yes, we could go on and bore you by going into the history of the Bollinger band, how it is calculated, the mathematical formulas behind it, and so on and so forth, but we really didn’t feel like typing it all out.
In all honesty, you don’t need to know any of that junk. We think it’s more important that we show you some ways you can apply the Bollinger bands to your trading.
Note: If you really want to learn about the calculations of a Bollinger band, then you can go to www.bollingerbands.com
The Bollinger Bounce
One thing you should know about Bollinger Bands is that price tends to return to the middle of the bands. That is the whole idea behind the Bollinger bounce (smart, huh?). If this is the case, then by looking at the chart below, can you tell us where the price might go next?
If you said down, then you are correct! As you can see, the price settled back down towards the middle area of the bands.
That’s all there is to it. What you just saw was a classic Bollinger bounce. The reason these bounces occur is because Bollinger Bands act like mini support and resistance levels. The longer the time frame you are in, the stronger these bands are. Many traders have developed systems that thrive on these bounces, and this strategy is best used when the market is ranging and there is no clear trend.
Now let’s look at a way to use Bollinger Bands when the market does trend.
Bollinger Squeeze
The Bollinger squeeze is pretty self explanatory. When the bands “squeeze” together, it usually means that a breakout is going to occur. If the candles start to break out above the top band, then the move will usually continue to go up. If the candles start to break out below the lower band, then the move will usually continue to go down.
Looking at the chart above, you can see the bands squeezing together. The price has just started to break out of the top band. Based on this information, where do you think the price will go?
If you said up, you are correct! This is how a typical Bollinger Squeeze works. This strategy is designed for you to catch a move as early as possible. Setups like these don’t occur everyday, but you can probably spot them a few times a week if you are looking at a 15 minute chart.
So now you know what Bollinger Bands are, and you know how to use them. There are many other things you can do with Bollinger Bands, but these are the 2 most common strategies associated with them. So now you can put this in your trader’s toolbox, and we can move on to the next indicator.
I am in my mid-forties, an IT professional graduated with BE degree. Career-wise I am in mid-level management role working in a fulfilling job with some traveling in Asian region and some free time available to pursue other interests. I have been trading Forex for the past 4 years. So far, I have busted 2 trading accounts and wipe out $40K SGD. This blog is a record of a renew journey in trading Forex.
(4 Dec 2008)
