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Key Takeaways
- Bollinger Bands are a versatile technical analysis indicator used as a solution to find relative highs and lows in dynamic markets.
- Using market trends and Bollinger Squeeze are two of the most common techniques to trade with Bollinger Bands.
- Bollinger Bands work well with a number of different indicators, but some common ones include the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD).
- One of the most common mistakes that traders make when using Bollinger bands is to buy or sell when the price touches the Bollinger band.
- Be sure to use Bollinger Bands in conjunction with other technical indicators and market analysis to give yourself the best chance of success.
Bollinger bands are one of the most popular technical indicators used by traders. They are simple to use and can be applied to a wide variety of trading strategies. In this blog post, we will explain how Bollinger bands work and provide tips for how to trade with them successfully.
What are Bollinger Bands?
Bollinger Bands are a versatile technical analysis indicator widely used among traders. They were developed by John Bollinger as a solution to find relative highs and lows in dynamic markets. John Bollinger is a famous American writer, analyst, and contributor to the discipline of technical analysis known for creating Bollinger Bands. The Bollinger Bands book, written by John Bollinger, has been translated into eleven languages.
The BB indicator itself is comprised of an upper band, lower band and moving average line. The two trading bands are placed two standard deviations above and below the moving average (usually 20 periods). Using 2 as the number of standard deviations estimates that 95% of price data will be contained within the two bands.
As a rule of thumb, prices are deemed overbought on the upside when they touch the upper band and oversold on the downside when the reach the lower band.
As price action oscillates between the indicators upper band and lower band extremes, Bollinger Bands become an excellent tool to gauge volatility. When bands contract there is less volatility in the market, which is a great indication to use a range bound strategy. Likewise, Bollinger Bands will expand as the market becomes more volatile. At these times traders may employ a breakout or a trend-based strategy.
How to trade with Bollinger Bands
There are several different techniques involved in using Bollinger Bands to trade. The most popular are:
- Using market trends: Traders can identify entry signals using the bands as a measure of support and resistance.
- Bollinger Squeeze: Applying the volatility indications of the bands
TRADING THE TREND
The chart above shows the EUR/USD chart in an uptrend – depicted by higher highs and higher lows. Using the Bollinger Band indicator, the lower band is seen as a gauge of support. When price touches the lower band, traders use this as a signal to enter a long (buy) trade. This strategy works for both uptrends and downtrends. Take profit (limit) levels are generally taken from the upper and lower bands depending on trend. In this example, the upper band will be used as the take profit level.
In summary, trading the trend with Bollinger Bands is relatively simple:
- Identify the trend.
- Use upper and lower bands in conjunction with price movement to identify entry points
- Use respective upper and lower band as target levels
TRADING THE BOLLINGER BAND SQUEEZE
As mentioned previously, when the bands contract volatility is low and vice versa. The Bollinger squeeze looks for breakouts above/below the band depending on trend to be used as entry signs.
Highlighted in green shows these breakouts in an uptrend. Traders will look to enter at the indicated green circles. After each entry, it can be seen that the candles are ‘walking the Bollinger’ (following the upper band). After the breakout candle the bands expand implying greater volatility in the market.
The black shaded circles illustrate the point at which traders will look to take profit before looking for further breakout signals.
Now when trading the BB squeeze:
- Look for low volatility (contracting bands)
- Wait for breakout of upper/lower band
- Close trade when price action reaches moving average
Advantages of using Bollinger Bands
The Bollinger Bands indicator is a simple but useful tool for traders. Its main advantages are:
- Bollinger Bands can be used to trade trends. By combining Bollinger Bands with a moving average, traders can use Bollinger Bands as a measure of support and resistance in the market. This makes Bollinger Bands an excellent tool for trend traders.
- Bollinger Bands can also be used to trade breakouts. When Bollinger Bands contract, it signals that volatility is low. When the bands expand, it signals that volatility is high. Traders can use this information to enter or exit trades.
- Bollinger Bands are also a great tool for measuring market volatility. When Bollinger Bands contract, it signals that the market is relatively calm. When Bollinger Bands expand, it signals that the market is becoming more volatile. This can be useful information for traders who are looking to enter or exit trades.
Disadvantages of using Bollinger Bands
As with any indicator, there are some downsides of using Bollinger Bands which are as follows:
- Like other technical indicators, Bollinger Bands are lagging in nature and will only provide entry signals after a move has already started.
- Bollinger Bands can give false signals during sideways market conditions.
- Bollinger Bands do not predict price direction, but rather define the current trading range.
- Bollinger Bands will widen when Bollinger BandWidth (BBW) increases and contract when Bollinger BandWidth decreases. However, Bollinger BandWidth is not a very reliable indicator of future volatility.
- Bollinger Bands are based on past price action and do not take into account future market conditions.
Common mistakes to avoid
One of the most common mistakes that traders make when using Bollinger bands is to buy or sell when the price touches the Bollinger band. However, Bollinger bands are a lagging indicator, which means that they can only provide information about what has happened in the past, not what will happen in the future. As such, it is important to utilize Bollinger bands in conjunction with other technical indicators or market analysis techniques.
Another common mistake is to use Bollinger bands without considering the overall trend of the market. Bollinger bands can be used to trade both up trends and down trends, but it is important to remember that they are a lagging indicator. This means that they will not provide any information about where the market is headed in the future.
Tips for trading with Bollinger bands
- Look for BB squeezes as potential trade setups.
- Use BB to confirm other technical signals.
- Use BB to help identify overbought and oversold conditions in the market.
- Don’t rely on BB alone – make sure to use it in conjunction with other technical indicators and fundamental analysis.
Bollinger bands can be a helpful tool for traders, but it’s important to remember that they should not be used in isolation. Be sure to use them in conjunction with other technical indicators and market analysis to give yourself the best chance of success.
FREQUENTLY ASKED QUESTIONS
What do Bollinger Bands indicate?
Bollinger Bands are a technical indicator that can be used to measure volatility in the market and identify potential trading opportunities.
How do Bollinger Bands work?
BB works by measuring the standard deviation of the price of a security, which is then used to create upper and lower bands. Please refer to next question to find out details regarding upper band and lower band.
What is meant by “upper band” and “lower band”?
BB consists of three lines: the simple moving average (the centre band), an upper band and a lower band. In most cases, the upper band and lower band will be 2 standard deviations (+/-) off a 20-day simple moving average (the centre line), although this may be changed.
What is the best standard deviation for Bollinger Bands?
Use a 50-period moving average and a standard deviation of 3 to plot Bollinger bands. For scalping, this is generally considered the ideal Bollinger Bands setting.
How do you find the standard deviation?
The square root of the variance produces Standard Deviation. The next step is adding and subtracting twice the standard deviation from each point along the SMA. These are what give us our upper and lower limits.
When should you use Bollinger Bands?
Bollinger bands can be used in a number of ways, but they are most commonly used to trade breakouts or Bollinger band squeezes.
How do Bollinger Bands work?
Bollinger bands work by measuring the volatility of a security’s price. They are composed of an upper Bollinger band, a lower Bollinger band, and a simple moving average in the middle.
How do you calculate Bollinger Bands?
Bollinger bands are calculated using a simple moving average and the standard deviation of the security’s price.
What are some common Bollinger Band strategies?
Some common Bollinger Band strategies include Bollinger Squeezes, Bollinger Bands breakdowns, and Bollinger Bands reversals.
What is a Bollinger Band squeeze?
A Bollinger Band squeeze occurs when the Bollinger bands tighten up and the price of the security moves within a small range. This is often seen as a signal that a breakout is about to occur.
What is a Bollinger Bands breakdowns?
Bollinger Bands breakdowns occur when the price of a security moves outside of the upper or lower Bollinger band. This is often seen as a signal that the security is about to make a move in the opposite direction.
What is a Bollinger Bands reversal?
A Bollinger Bands reversal is when the price of a security moves from one Bollinger Band to the other Bollinger Band. This often signals a change in direction for the security
What is the difference between Bollinger Bands and Bollinger Envelopes?
Bollinger Bands are composed of a simple moving average in the middle and two Bollinger bands (upper and lower) that are placed two standard deviations away from the simple moving average. Bollinger Envelopes are similar to Bollinger Bands, but they only have one Bollinger band (upper or lower) that is placed two standard deviations away from the simple moving average.
Which indicator works best with Bollinger Bands?
Bollinger Bands work well with a number of different indicators, but some common ones include the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD).
Conclusion
Bollinger Bands are a great technical indicator to add to your trading toolbox. They can be used alone or in conjunction with other technical indicators to help you make more informed trading decisions. Remember to use Bollinger Bands in conjunction with other technical indicators, and always use risk management when entering any trade.
Do you have any questions about Bollinger Bands? Let us know in the comments below!
