Bollinger Bands are great indicators for the measurement of market volatility. Most of the traders use this indicator religiously. The Bands helps you to establish the direction of a trend, locate potential reversals and monitor volatility. If you follow a few guidelines, these will aid you in making better trading decisions. The Bollinger Bands indicator works on simple maths and is easy to comprehend.
But how can we apply these indicators to trading and which strategies will generate victorious results? Well, in this article, you will learn what Bollinger Bands are and how you can use them as an indicator.
Bollinger Bands- What are they?
Bollinger Bands are named after a technical analyst, John Bollinger, who developed them in the 1980s and trademarked the term in 2011. Although Bollinger was not the first person to research moving averages, he was unique since he added bands below and above the moving average line to define lower and upper rate boundaries. These boundaries are later utilised for the measurement of volatility.
In simpler words, this technical tool has three different lines drawn: a security price line, one line above it and one line below it. The lines depict a volatility range or a band in which a security price is going up and down. The measure of volatility employed in this analysis tool is a standard deviation of a particular security. To what extent an exchange rate varies over time is volatility. Traders pay close attention to volatility because it usually increases just before a rate reversal. And as the reversal gains speed, volatility tends to increase sharply as traders take advantage of the upward or downward direction.
These bands show how a security price has reached in a specific duration and its relative strength by stages of different highs and lows. The highs lay near the upper line whereas the lows lay around the lower line. The bandwidth widens if the volatility is high and narrows if the volatility is low.
This method is similar to Moving Average Envelopes. But the difference lays in calculating them. In Moving Average Envelopes, the lines are drawn on the basis of fixed percentage but in Bollinger Bands, the upper and lower lines are jotted using standard deviation.
Although Bollinger took inspiration from the Envelope Theory, he made the Envelope Theory dynamic by using a 20-period moving average instead of keeping it fixed and made bands using standard deviations.
Traders benefit by Bollinger Bands by reading overbought or oversold stocks. This is a common strategy. A stock is overbought when the stock goes beyond the upper-end of a Bollinger Band and is oversold when the stock goes down the lower band.
Benefits of Bollinger Bands
User-friendly
The bands are easy to comprehend and intuitive which makes then very popular. Because these bands have a parameter or SMA for comparison, reading them is easy.
Flexibility
Usually, the Bollinger Bands are set two deviations away from the SMA. But you can always modify them according to your understanding. It is the easiest to start with default settings first. With increased knowledge and understanding, you can make adjustments as you like. Thus, Bollinger Bands are flexible allowing you to adjust the placement of the bands according to your preferences and needs.
An easy indicator of an overbought or oversold market
Bollinger Bands are an easy way to know if the market is oversold or overbought. If the prices move closer to the upper band, an overbought market is signified. But, on the flip side, if the prices linger in the lower bands, it is an indication of the oversold market. There are not absolutes but are great indicators.
Identify trends
If the bands move further apart making the lower band proceed into the opposite direction of the trend, it is an indication of expanded volatility caused by strong trends. On the other hand, if the trend is weak, the lower band will move in an upward direction. It helps in not only identifying trends but also figuring out if it is making a pattern.
Useful for every kind of traders
The best part about these bands is that they are useful for every type of trader, from day traders and swing traders to long-term traders. They are also appropriate for both high-priced and low-priced stocks.
Even currency traders trading in forex are constantly trying to locate trends in price movements and these bands help them by signalling changes in the volatility of their currencies.
Well-structured
Bollinger made sure that his analytical tool if full-proof. Thus, he created a list of twenty-two guidelines and rules for using them appropriately. The rules give a framework to the new traders, helping them immensely.
Calculation of Bollinger Bands
The bands involve 3 easy calculations:
- The middle or first Bollinger Band is the moving average of the closing price. Usually, the standard period taken for calculating the bands is of 20 days.
- The second line denotes the upper Bollinger Band. For the calculation of this, you need to calculate the moving average of the closing prices and then add twice the daily standard derivations to it.
- The lower Bollinger Band is represented by the third line. To calculate this, you will have to calculate the moving average of the closing prices and then subtract twice the daily standard deviations from it.
The formula for calculating Bollinger Bands:
- Middle Band = 20-day simple moving average (SMA)
- Upper Band = 20-day SMA + (220-day standard deviation of price)
- Lower Band = 20-day SMA – (220-day standard deviation of price)
The Bollinger Band indicator can enhance the analysis by assessing the potential strength of the formations. If interpreted correctly and in time, a trader can benefit a lot by interpreting these common trends.
Overbought and Oversold stock
Overbought stocks are vulnerable to profit-taking whereas oversold stocks often bounce up as bargain-hunters purchase them.
When the price of a stock falls below the lower Bollinger Band, a trader will buy the stock expecting the price to return to middle Band. And when the price of the security goes above the upper Bollinger Band, a trader will sell the asset again bringing the price back to the middle Band. This type of strategy lies in the mean reversion of the price, meaning, it assumes that if a price fluctuates substantially from the mean, the price will eventually come back to the mean price.
This technique works well in the range-bound markets as the prices bounce up and down the bands. However, this technique is not always accurate. A trader will be placing trends constantly on the wrong side of the move during a trend. But a trader should look at the overall movement of the price and then interpret the trade signals.
Bollinger and RSI
To strengthen the success of the trade, traders combine Bollinger Bands with other indicators. The Relative Strength Index (RSI) is one of them. It is an oscillator that lingers between 0-100 which over a period of time compares total days security closes up against closing down.
When the RSI reaches above 70, overbuying is expected. If the RSI remains under 30, oversold securities are expected.
If the RSI reads above 70 and the price of security touches the upper band of the Bollinger Band, the security is considered to be overbought and can be sold.
If the price remains in the lower Bollinger Band and the RSI is above 30, it is indicated that a downtrend could continue and it is not an oversold situation as suggested by the Bollinger Band. The trader would not buy more stock as the price is expected to further go down. The trader could consider selling if the RSI is high enough.
The Bollinger Bounce
The Bollinger Bounce strategy is for the people who like asking for very little from the markets. Basically, the trader seeks for the opportunity that the market deflects the bands back to the middle of the bands. Eventually, they will be able to diminish the wild fluctuations of their account balance.
The traders buy when prices hit the lower Bollinger Band and sell their securities when the prices are high. The profit margin is not huge.
The Bollinger Squeeze
The squeezing of the middle band, by the lower and the upper one, generally means that a breakout is about to happen. In case the candles begin to break out of the top band, then the move will typically continue to mount. But if the candles begin to break out below the lower band, then the price will frequently continue to fall. This strategy is designed for the traders to catch a move as soon as possible.
The squeeze happens when the market becomes too slow and there is low volatility. As a result, the price moves sideways and the pattern appears to be squeezed. However, the market is not going to remain calm forever, and the low volatility will end with strong movements. If traders invest wisely and at the right time, this strong movement might prove to be profitable.
W-Bottoms
The W-Bottoms signifies a reversal from a downtrend into an uptrend. There are a total of 16 W patterns as identified by Arthur Merrill from the basic W shape. A W pattern is formed by two reaction lows with a high in between in a downward trend. You can identify a ‘W’ in the pattern. Bollinger, however, looks for W-Bottoms where the second low remains above the lower band but lies lower than the first low.
There are four steps for confirming a W-Bottom with Bollinger Bands.
- A reaction low is formed. It is usually below the lower band, although sometimes it can be above the lower band.
- The price bounces back to the middle band creating a rising line.
- The price again drops but remains above the lower band. This shows that the last decline is not that strong.
- The pattern is finally confirmed when a strong move drags the second low above again.
M-Tops
It signifies a reversal from an upward trend into a downward trend. The pattern resembles the letter ‘M’. Arthur Merrill also identified 16 variations in M-Tops. The first high can be lower or higher than the second-highest. Bollinger suggests looking for non-confirmation by identifying these changes.
This type of pattern can be identified when the price moves closer to or beyond the upper band. The price is then pulled back to the middle or lower band. Thus the price rises again but the price line remains below the upper band this time. The price line is again deflected to the middle band as it fails to remain near the upper band. This pattern is a bearish indicator signal.
Walking the bands
Bollinger suggests that moves that touch or go beyond the bands are not signals but tags. A steep move to the lower band indicates weakness while a rise towards the upper band shows strength.
An overbought situation is not always bullish as it takes strength to reach there and overbought conditions can extend in a powerful upward trend. Similarly, prices can “walk the band” with multiple touches during a strong uptrend. It takes a very powerful price move to cross the upper band as it is 2 standard deviations above the 20-day SMA.
So, if the upper band is touched just after a W-Bottom pattern, an upward trend will begin. It is also highly possible that prices will never reach the lower band during an upward trend with multiple upper band tags.
Riding the Bands
Selling the stock when its price touches the upper band or buying it when the price reached the lower band is a big mistake. Bollinger suggests that mere touching of upper or lower bands does not signify selling or buying of the stock.
But why? It is because the price may begin to trend outside the bands. And if a trader does not wait before buying or selling, a hugely profitable setup will be missed. Therefore, riding the bands is recommended.
How do you ride? Look at the middle line. If it is pulling back but not breaking, there might be room for growth. However, if there is a reversal or big acceleration beyond bands, then it is wiser to scale down in your position.
Which Strategy Works the Best?
Everybody wishes to know which strategy among the top Bollinger Bands strategies would work the best. However, it is difficult to answer this question since every strategy works differently for different traders.
Usually, snap back to the middle of the bands and trade inside the bands work for most people. However, it is not necessary that these will work the best for your market.
Bollinger Bands Limitations
The bands are derived from SMA or the average price of a certain number of price bars. This means that the bands will move as a reaction to the price change but will not predict the change in prices. These bands are, therefore, reactive and not predictive.
Even the standard-setting does not work for all traders as active traders want a smaller count of periods or lower standard deviation, whereas, long-term traders prefer a greater standard deviation and a larger count of periods.
If the settings are adjusted, it would be difficult to interpret the trends, specially W-Bottoms and M-Tops. The W-Bottoms and M-tops may not be reversals but just consolidations in which prices continue to move in the trending direction after a false breakout. The breakout is false when the prices pass through the entry point initiating a trade but quickly moves in the other direction, resulting in a loss.
Bollinger Bands do not tell when the selling or buying pressure will end during overbought or oversold situations.
Interpreting the bands is easy to recognise or analyse on sheet but is very difficult in real-time. New and unskilled traders cannot use Bollinger Bands to immediately recognise a pattern in real-time.
Not all bands signals are true. In fact, most of them are fake. For example, if the stock volatility is low, the bands will contract. The prices may move upwards or downwards but it will not be a sign of reversal.
Adverse conditions can damage reliable patterns very quickly. The impact of national or international news or unexpected accidents can have a huge impact on the trends in the market.
Conclusion
Bollinger Bands help a trader to get in the habit of pondering about volatility. In order to take your trading to the next level, you must settle on a market that you wish to master, figure out the best time frame for you, and learn to master any one strategy. Just because the price is touching either of the bands, it does not mean that it is the right time to sell or buy the stock. Patience is the key to make maximum profit.