The Bollinger Bands was created in 1980, named after the man who invented it, John Bollinger. This indicator utilizes a moving average and two trading bands above and below.
In this article, we will explore the concept of Bollinger Bands, their construction, and their practical applications. Whether you are a seasoned trader or a beginner in the world of finance, this comprehensive guide will equip you with the knowledge needed to effectively utilize Bollinger Bands in your trading strategies and enhance your decision-making process.
Isolated on a chart, the Bollinger bands look like this:
Additionally, how the bands of the Bollinger bands indicator work will be explained, they measure volatility and use it to adapt to market conditions, overbought or oversold conditions.
Prices are thought to be overbought when they hit the upper band, while it is oversold when the price touches the lower band.
How Does The Bollinger Bands Work?
When this indicator is placed on a chart, three components are noticed. They are:
- The Upper Band
- Middle Line
- The Lower Band
The upper and lower bands contract and expand in relation to price action. In volatile market conditions, the bands expand. As opposed to that, during a ranging market, the band’s contract.
Moreover, volatility is measured using standard deviation, showing how the pair’s price can vary from its original price.
The middle line of the Bollinger band is typically a simple moving average, usually set to 20 bars. As always, this period can be adjusted to suit your trading plan.
What Does The Bollinger Bands Tell You
It is believed that the closer the prices move to the upper band, the more overbought the market is. Also, the closer the prices move to the lower band, the more oversold the market.
Standard deviation is used to measure volatility. Thus, the bands expand in volatile conditions and contract in less volatile markets.
Bollinger Bands Calculation
To begin, the middle line is reviewed first. The middle line is a simple moving average.
Assuming a 20-bar moving average, the mean of the closing prices of the previous 20 market sessions is taken and then plotted.
As for the bands, the standard deviation of the currency pair will be obtained. Standard deviation is the average amount of variability for a given amount of data. It is commonly used in economics and accounting.
Standard deviation is calculated by taking the square root of the variance, which is obtained by averaging the mean squared differences.
Then, the value for the standard deviation is multiplied by two. The result is both added and subtracted from each point along the SMA. Plotting this value gives the upper and lower bands.
The formula for the procedure explained above is:
Upper Bollinger band = MA (TP, n) + m * σ [TP, n]
Lower Bollinger band = MA (TP, n) – m * σ [TP, n]
MA = moving average.
TP = Typical pricing= (high + low + close).
n = the period of the moving average.
m = number of standard deviations.
σ [TP, n]: standard deviation over the last n periods of TP.
Trading The Bollinger Bands Explained
Over the years, various strategies have been developed to trade the Bollinger bands. Some of these strategies will be buttressed below.
Naturally, the price always tends to return to the middle line. With this in mind, when the price reaches the upper band, we would expect it to reject it and head to the middle line.
As seen above, this rejection is known as a Bollinger bounce. These bounces occur because the bands act as dynamic support and resistance levels.
They act just like regular support and resistance levels but are never situated in one position; hence, they are dynamic.
The higher the time frame, the stronger the bands. So, more emphasis should be laid on higher time frame bands.
Although, this way of trading with Bollinger is only valid when the market is not trending. One way to identify that is by looking at the width Bollinger band.
Expanding bands denote a trending market, while stable and contracting bands suggest a slow market.
When the bands of the Bollinger squeeze together, it means a breakout is imminent. This action shows low volatility in the market.
An upward breakout occurs when candlesticks start to break out from the top band.
On the other hand, a downward breakout occurs when the candles start to go beyond the lower band.
A drawback with the Bollinger Band squeeze is that it rarely happens.
READ MORE: A Guide To Understanding The Dow Theory
Bollinger bands consist of a moving average, upper, and lower bands. The moving average adopted is a simple moving average. Further, the standard deviation is used to determine the location of the bands.
When the indicator bands are spread out, it indicates high volatility. Meanwhile, when the bands contrast, volatility is low.
Also, the bands help to determine overbought and oversold regions. The upper band represents an overbought condition for a stock/ commodity.
Differently, the lower bands show an oversold condition for a stock/ commodity.
With the Bollinger bands, when the price is at the upper band, it is a sell signal.
Inversely, the price being at the lower band shows an oversold condition. Thus, it is a buy signal.
Summary: The Bollinger Bands Explained
The Bollinger bands indicator is not sufficient to be used alone. However, it can be used for short-term trends and to measure volatility.
As instructed by John Bollinger, they should be used with other indicators to provide more market overviews.
Lastly, the Bollinger bounce can only be used in low volatility, and the Bollinger squeeze rarely happens.