A Bollinger Band is an indicator tool that is widely used in technical analysis of financial markets. This technical indicator is composed of three different lines, where one sits below and one above the asset price.
Bollinger Bands technical indicator was first introduced by the US-based technical analyst John Bollinger in the 1980s. He created a technical indicator based on the specific parameters (more on that later).
In this blog post, you’ll learn:
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In practice, Bollinger Bands represent one of the most potent and reliable trading indicators in the world of technical analysis. This indicator is mainly used to interpret the strength of a trend and identify market tops or bottoms.
The first thing you would've noticed notice from this chart is the three wavy bands: the upper band, middle band and lower band. Here's a few key points to bear in mind when analysing Bollinger Bands:
As we mentioned earlier, Bollinger Bands consist of three different lines. The centre line is a simple moving average (SMA), whose default value is usually 20. These values can be adjusted to fit the requirements of each person’s unique trading style.
The upper Bollinger Band represents a value that is two standard deviations above the average (a positive deviation). Conversely, the lower band represents a value that is two standard deviations below the average (a negative deviation).
Bollinger Bands generate different values that change with movements in the underlying market value of the asset. In other words, when the market activity becomes more volatile, the bands will spread farther apart. When market activity slows, the indicator will contract.
Bollinger Bands trading is mainly centred around analyzing the strength of trends. In general, during strong trends, price action usually stays close to the outer band. Oppositely, the momentum is waving if the price pulls away from the outer band as the prevailing trend continues.
Of course, Bollinger Bands trading should not be thought of as a stand-alone system. Instead, it can be used to provide market traders with important information regarding the potential price volatility of an asset.
For this reason, expert traders will often use this technical indicator in conjunction with another indicator. Moving Average Convergence/Divergence (MACD) and Relative Strength Index (RSI) technical indicators are often used to validate Bollinger Bands signals.
Defined as a degree of positive or negative price variation over time, volatility is generally measured through standard deviation. The typical Bollinger Band standard deviation measures the distance between current asset prices. It then compares that value to the average price of the asset over the previous 20 price periods.
In order to calculate bands, you should first identify a simple moving average. Secondly, you need to add or subtract a specified number of standard deviations from the simple moving average. This produces the values which define the upper and lower bands.
Roughly 95% of all price action is expected to occur between the upper and lower Bollinger Bands. For this reason, the Bollinger Band strategy is ideal for ranging market conditions.
This technical indicator shows price extremes that are likely to contain market activity. Thus, any breakout above or below the boundaries represents a major event in the market.
As a result, prices rising above the upper band indicate overbought markets and therefore generate a sell signal. Conversely, prices falling below the lower band indicate oversold markets and issue a buy signal.
These signals are further strengthened when prices fail to close above/below the Bollinger Band envelope and leave a long candlewick. This represents an additional (confirming) signal indicating that a potential reversal in the price direction is about to take place.
Therefore, some traders use Bollinger Band to identify reversal points. This strategy is also called a “contrarian Bollinger Band strategy”.
Next, we will present how a basic Bollinger Band strategy will help you make profits. By looking at a real-time trading situation, we will assess Bollinger Band buy and sell signals. We can see that a strong downtrend in market momentum forced prices below the lower Bollinger Band.
This move created our initial buy signal as prices began to trade outside of the 95% containment region. Additionally, the price broke above the mid-line to further justify the buy signal.
Next, we can see that valuations move sharply higher to reach the upper boundary of the Bollinger Band. This occurs without market prices breaking above the upper boundary signalling that markets have not become overbought. Therefore, the current rally remains sustainable within the 95% containment zone).
From here, markets continue moving higher. Eventually, the reduced liveliness in the markets constricts the Bollinger Band structure and price falls below the 20-day SMA mid-line. This is a minor signal which suggests bullish momentum is beginning to weaken.
Thus, it is not surprising to see a sell signal quickly developing – the first downward arrow on the chart. The market prices then finally breach the upper band. At this stage, traders are left with an important decision to make. Is it time to close the trade or continue with the underlying bull position?
Of course, these types of questions are determined by individual risk tolerance. A conservative trader might decide to collect profits given the strong gains that have already been made. A more aggressive trader might choose to stay in the long trade and chase bigger profits. When prices bounce from this line, it gives us additional evidence that the upward trend is still in play.
From here, the price continues moving higher until valuations breach the upper band once again – the second downward arrow. On this second break, the trend has reached its end, which is apparent when prices ultimately fall below the 20-day SMA. At this stage, all signals to close the long trade have been generated and a trader is advised to collect profits.
In the second example that we will present, we will witness the efficiency of the Double Bollinger Bands trading strategy. This strategy allows you to trade Bollinger Bands in ranging markets. For this reason, traders often use a Bollinger Bands Forex Strategy.
Double Bollinger Bands strategy advises you to enter long trades when price breaks below the lower standard deviation and vice versa. This way, you will be trading Bollinger Bands on both sides of the market.
On the left part of the chart, gold prices have fallen sharply through the lower band. A buy signal is generated at $1,490 as prices are now expected to move higher in the short term.
Stop losses for the trade can be set at $1,486.50 and this allows us to set a profit target at $1,510.20. These trading parameters allow us to keep a favourable risk-reward ratio of at least 3:1. Shortly afterwards, our target is reached.