Content
Bollinger Bands are one of the most popular technical analysis tools implemented in today’s trading environment. Here we take a look at the mechanism behind the indicator as well as Bollinger Bands strategies available to traders.
What are Bollinger Bands?
As the name implies, Bollinger Bands refer to the bands (price channels) placed on a chart to represent a volatility range in which a particular security price goes up and down.
Components of Bollinger Bands explained
The three components of Bollinger Bands include:
The middle band: a 20-period simple moving average (MA).
The upper band: Set up above the middle band by a certain number of standard deviations of a price.
The lower band: Setup below the middle band by a certain number of standard deviations of a price.
When using Bollinger Bands, traders get to choose two parameters:
Period: This is the period used in SMA, and it can be five minutes, an hour or a day.
Standard deviation (StdDev): This parameter represents a statistical measure of market volatility, which indicates how widely prices are dispersed from the average. The default value for StdDev is 2, although it’s customisable depending on approach.
Setting up Bollinger Bands on trading platforms would depend on your broker’s layout. Usually there would be a toolbar where traders can choose between different technical indicators, and Bollinger Bands would appear there.
How to use Bollinger Bands in trading
As the upper and lower bands represent standard deviation, it means they are based on price volatility. When the bands contract and lie close together, a period of low volatility is indicated.
Conversely, when the distance between the bands expands, an increase in market volatility or price action is found. If the bands begin to form a slight slope and track almost parallel for an extended period of time, the price will usually be found to swing between the bands as though in a channel. Defined by standard deviation, the bands also establish where the support and resistance levels might be.
The main idea behind Bollinger Bands trading strategy is that by comparing an asset’s position relative to the bands, a trader could determine whether an asset’s price is relatively high or low.
If asset prices continuously touch the upper Bollinger Band, the prices are considered to be overbought. Conversely, if they continuously touch the lower band, prices are thought to be oversold.
Bollinger Bands trading strategies
How to trade using Bollinger Bands would vary depending on trading style and goals. Below are some techniques traders could consider while using Bollinger Bands.
Overbought and oversold strategy
This Bollinger Bands trading strategy relies on the mean reversion of the price. Mean reversion expects that, if the price significantly deviates from the average, it will eventually revert back to the mean price.
As we already know, Bollinger Bands identify asset prices that have deviated from the mean. Thus, when the price of the asset breaks below the lower band, a trader using this strategy would consider entering a long position seeking the price to revert back to the SMA band.
Conversely, when the price breaks above the upper band, the trader following this strategy would consider opening a short position betting on a move back to the middle band.
Squeeze strategy
Another Bollinger Bands strategy is known as a squeeze, which refers to the narrowing of the trading range and implies an impending breakout.
It happens when the price is moving aggressively and then suddenly starts shifting sideways in a tight consolidation. A trader can visually identify when the price of an asset is consolidating as the lower and upper bands get closer together on the chart. It means the volatility of the particular asset has decreased.
After a period of consolidation, the price usually tends to make a larger move in either direction, ideally on high volume. Note, however, that this is based purely on the observation of past performance, which does not guarantee future returns.
Expanding volume on a breakout is a sign that traders are speculating that the price will continue to move in the breakout direction. When the price breaks through the lower or upper band, the trader sells or buys the asset respectively. A stop-loss order is traditionally placed outside the consolidation on the opposite side of the breakout.
Note that an ordinary stop-loss order doesn’t protect from slippage. For a fee traders can purchase a guaranteed stop-loss, which ensures slippage does not occur.
Double Bollinger Bands (DBB)
Traders who use this Bollinger Bands trading strategy add two sets of price channels to their price chart. The first one is set to default parameters: period of 20 and deviations of two (BB2, or the outer BB). The second Bollinger Bands are set to the period of 20, but deviations of one (BB1, or the inner BB).
The area between BB1 and BB2 upper bounds would be used as the Buy Zone, while the area between BB1 and BB2 lower bounds will be considered a Sell Zone. The area in between upper and lower BB1 bounds is used as the Neutral Zone.
Traders who use DBB can either trade breakouts or follow the trend. They would watch out for a strong shoot into the Buy Zone or Sell Zone, and open a long or short position accordingly.
Conclusion
Bollinger Bands is a useful technical tool in a trader’s arsenal and refers to price channels placed on a chart to represent a volatility range of an asset’s price. Bollinger Bands consist of the middle, upper and lower bands, and are set by period and standard deviation. The default setup is usually 20-period with the standard deviation of two.
The key concept behind Bollinger Bands is that by seeing the price in the context of the bands, a trader can evaluate whether the price is relatively high or low.
Some of the Bollinger Bands trading strategies include overbought and oversold approach, squeeze strategy and Double Bollinger Bands (DBB).
FAQs
What are Bollinger Bands and how do they work in trading?
As the name implies, Bollinger Bands refer to the bands (price channels) placed on a chart to represent a volatility range in which a particular security price goes up or down.
How to use Bollinger Bands to identify market trends?
Some of the Bollinger Bands trading strategies include overbought and oversold approach, squeeze strategy and Double Bollinger Bands (DBB).
Can Bollinger Bands be used for day trading?
Yes, Bollinger Bands can be used in day trading to identify daily uptrends and reversals.
What are the best indicators to use with Bollinger Bands?
Any non-related indicator can be used in conjunction with Bollinger bands as they will serve to strengthen or dismiss the assumption of a trend. That said, bollinger bands are commonly used in conjunction with the relative strength indicator (RSI) as it also indicates oversold or overbought conditions.
