How To Use Bollinger Bands
This indicator can be a great asset to technical analysts because it can be used to gauge market conditions, spot entry opportunities, and set targets.
- Maths behind Bollinger Bands.
- What does this indicator tell us?
- Trading with Bollinger bands.
Maths behind Bollinger Bands
Firstly, you must decide the period over which the indicator is calculated (the most common setting is 20). This is plotted on the chart as a simple moving average (SMA) and forms the middle band of the indicator.
The top band is calculated using the value of the SMA plus a standard deviation, and the bottom band uses the same value minus the standard deviation. Usually, a standard deviation of 2 is used in this indicator.
Middle band – SMA (default of 20).
Upper band – SMA + 2 standard deviations.
Lower band – SMA – 2 standard deviations.
But what is standard deviation? In basic terms, it is a measurement of how spread out numbers are in a given set of data. Therefore if there is a large variance, the Bollinger bands will widen; if there is little variance, the Bollinger bands will tighten.
What does this indicator tell us?
Overbought and oversold conditions
Bollinger bands are designed to show when the market may be overbought or oversold at a given time.
When price is trading at or near the top line, the market is seen as overbought. Therefore the market may reverse or pullback before continuation.
When the market is at or near the bottom line, the market is seen as oversold. Leading to a potential reversal or a retracement before continuation.
Overbought and oversold indications
Volatility is a measurement of how much price moves within a period. High volatility means large movements, while low volatility means small market movements.
As mentioned earlier, should prices have a significant deviation, the Bollinger bands will expand. This means that wide or widening bands are a great signal of high volatility.
Should there be an insignificant deviation, the Bollinger bands will shrink. Resultingly tight or tightening bands are a sign of low volatility.
Essentially the width correlates to the level of volatility.
Foremost, since low volatility usually equals ranging/ choppy markets and high volatility usually leads to trend, we can deduce the following:
- Tight Bollinger bands for an extended period means that the market is likely choppy/ range-bound.
- Wide Bollinger bands for an extended period means that the market is probably trending.
Furthermore, we can also use the indicator to gauge transitions from one environment to another:
- If the separation was wide but is now shrinking, the market could be transitioning from a trend to a range.
- If the separation was small but is now widening, the market could breakout and transition from a range into a trend.
Support and resistance
Statistically, the upper line is overvalued and the bottom line is undervalued. Therefore some traders believe that this indicator can act as a traditional zone.
I prefer to base my analysis of supply and demand on the actual price action of the market rather than an indicator, but below are charts showing how this can be implemented.
Bollinger bands acting as support
Bollinger bands acting as resistance
Now that we understand the various pictures that this tool paints, let us dive into how it can be applied when trading.
Trading with Bollinger bands
Probably the most common way to trade this tool is through an approach called the Bollinger squeeze.
This occurs when price action is contained within a tight gap, and then the market breaks out past one of the bands. After this, a trend is expected to follow.
It is always best to wait for a candlestick close above or below the lines to confirm the validity of the breakout.
Bollinger squeeze trade
Using the bands as support and resistance
Next up, we will apply the already mentioned principle that the lower band can act as support and the upper band can act as resistance.
Should the market test the lower band and provide confirmation, a buy trade would be placed.
Should the market test the upper band and provide confirmation, a sell trade would be placed.
It is a well-known fact that trends occur on higher volatility, and when market activity slows this signals that a reversal could occur.
So when the Bollinger bands start to contract during a trend, this means a reversal could be on the horizon.
I haven’t shown the normal Buy label and arrow on the chart below, because using the indicator in this way does not provide an entry signal to time the trade. However, it does warn us to look out for a shift in the market.
In buy positions, the upper band of the indicator provides a guide as to where bulls may lose strength. Resultingly the market may reverse or retrace.
In sell positions, the lower band of the indicator gives a signal as to where the bears may have less force. Thus price could reverse or retrace.
What does this mean for your trading? Simple, the opposite band can be used for trade management and potential profit targets.
You might be a bit shocked about how much this one indicator can tell you? I must stress that Bollinger bands are not a standalone trading system, it should be used in conjunction with price action and other tools.
But there is no harm in testing the indicator out and objectively determining if it works in conjunction with your approach and takes your results to another level.
All the best!
Risk disclosure – Trading CFD’s carries risk, losses can exceed deposits.
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