What are Bollinger Bands?
Traditional conventional technical analysis tools and indicators are often used in combination with financial and accounting calculations to establish new indicators which are adopted to the current market developments.
One of the noticeable results of such adoption was established by a technical analyst - John Bollinger in mid 1980, patented in 2011. John Bollinger used his last name when giving the name to his brainchild - Bollinger Bands.
Bollinger Bands is a widely used indicator, which plots the 20 day Simple Moving Average - SMA20 and it’s deviations into the chart to create a band. The Bollinger Bands indicator consists of three main attributes: SMA20, Upper Band and Lower Band. Upper and Lower bands are standard deviations of the SMA. Standard deviation is a mathematical formula used to measure the volatility of an asset.
The Formula is as below:
Middle Band - SMA20
Upper Band - SMA20 + (20-period standard deviation of price x 2)
Lower Band - SMA20 - (20-period standard deviation of price x 2)
On the chart, the Bollinger Bands look like the following:
In the chart used above, 20-day simple moving average and its deviations created a Bollinger Bands which is a more flexible variation of a regular price channel. The contraction and broadening of bands are explained by the standard deviation used, which identifies the volatility of an asset, whereas contraction stands for the less volatility and broadening stands for the high volatility of the asset’s price.
How to trade Bollinger Bands?
Trading with Bollinger Bands requires good knowledge of the technical analysis, basics of the moving average, price action and trend determination. It might look complicated at first glance but using Bollinger Bands to identify short-term trend reversals could be as easy as drawing a trendline.
When the volatility of the price increases, and the price hits the upper band of an asset, there is a clear signal of the short-term correction. Vice versa, when the volatility of an asset is too low and the so-called “squeeze” is formed, there is a high chance of a trend continuation or even a trend reversal.
When the Bollinger Band contracts, as a rule, traders consider entering the market for the trend-continuation trade setup. It is expected that after the low volatility period, the asset should experience a high-volatility period and demonstrate greater moves. In the squeeze it is essential to track the future price action of an asset inside the band, applying support and resistances.
As seen on the chart above, the price experienced a high volatility after being calm for some time.
There are more conservative ways of trading Bollinger Bands, as the volatility in the market can be outstanding, and waiting for the perfect squeeze could take time. Trading within ranges could be one of the options to take the best of trading with Bollinger Bands.
When the price hits the lower band, it could signal the buy trade, and when it hits the upper band, the indicator signals the short trade.
As said before it is essential to follow the trend and apply other techniques to identify the best trade setup, as the price could actually fake the touch and breakout. Bollinger Bands breakout is in fact another trading technique used by many traders. Usually breakouts signal a high volatility and a strong price action in the direction of the breakout. See example below.
Since its signal lines are purely based on volatility it is recommended to use oscillators for a better precision and highly recommended to identify local support and resistance zones.
It is always advised to apply risk management and risk/reward ratio when trading these indicators. As a general rule, a trader should place the Stop Loss (SL) 10 pips above the high of the candle that touched the upper band for short, and 10 pips below the low of the lower band of the candle that touched it for long. When trading the breakout, a trader puts the SL 10 pips below the SMA20 or based on the support/resistance breakouts of the asset. Place your Take Profit accordingly, based on the distance calculation. Best to use these patterns with oscillators and indicators, for example: RSI, MACD, Momentum, Williams R%. Train your knowledge on Overbit’s demo account to firm your trading skills.