This is crazy:
Trading has recently become a trendy activity (almost) everyone wants to try at least once. This results in many more market participants, which itself generally increases market volatility.
Think I’m exaggerating?
Take the FOREX market for example. It’s the largest and most liquid market with more than 5 USD trillion traded every day. It’s also one of the most volatile markets, attracting more and more traders by the day.
What are the Bollinger Bands?
The Bollinger Bands indicator is a very useful tool to know when markets are quiet or volatile. Volatile markets offer more trading opportunities than flat ones. However, volatility increases both your chances of making money and losing it. For this reason, it’s important to have a sound trading plan before investing. Preparation, patience, dedication, and commitment are key personality traits every trader should have.
Here’s the point:
Bollinger Bands are a mathematical indicator plotted on your chart. They help you visualize when prices might be about to reverse, using overbought and oversold levels based on standard deviation. As explained in our Basic Techniques In Technical Analysis article: “graphs will be the primary supply of information for technical analysts”. These analysts only use the price action to determine future price direction. They will also use chart patterns and mathematical indicators derived from prices.
You’ve got it:
As Bollinger Bands envelope prices, and as their calculations are based on prices themselves, technical analysts often use this indicator to help decide whether or not to enter the market.
With this article, you will have a better understanding of what Bollinger Bands are and how to use them.
Understanding Market Volatility
We can’t talk about Bollinger Bands without talking about volatility, which represents the velocity or price changes of a market. Many traders choose the Forex market due to its inherent volatility. Know, however, that volatility is a double-edged sword, and you can easily find yourself on the wrong side of it…
Price volatility occurs due to many different factors:
- Strong change in the demand/supply of an asset
- Wars and conflicts, as well as geopolitical uncertainties
- Natural disasters
- The weather
- Technological changes
- Companies earnings
- Interest rates
- Government fiscal policy and central bank monetary policy
- Traders’ emotions
- Fat finger errors and high-frequency trading
Historical volatility and implied volatility are among the most used ways to measure volatility that you will find. Also, historical volatility looks at the past, while implied volatility describes what the market sentiment suggests what may happen.
Why do I say this?
Historical volatility is based on statistical volatility, which heavily relies on a standard of measurement called standard deviation. This statistical measure is also used in the computation of the Bollinger Bands indicator developed in the 80’s by John Bollinger.
Let me explain:
Standard deviation is helpful to determine the upper and lower bands playing the role of resistance and support levels.These bands represent the nervousness of the markets. It provides a sort of boundary of high points and low points, which can create a profitable entry and exit points.
The Bollinger Bands
The Bollinger Bands indicator is composed of 3 lines:
- A simple 20-Day moving average
- An upper band
- A lower band
As we explained in the above article, there are different types of moving averages.With the simple moving average (SMA) the weight given to each new point in the data series is the same.A 20-Day SMA will add up the closing prices for the past 20 days and divide the result by 20.
Bollinger Bands can be added to an SMA. The upper line is drawn by adding 2 standard deviations to the SMA, while the lower line is drawn by subtracting 2 standard deviations from the SMA. In statistics, according to the Normal (or Gaussian) distribution, more than 95% of all values are expected to be in the range of +2 standard deviations from the mean value.
The Bollinger Bands represent the area where 95% of the prices should evolve. From this, we can then assume that whenever the price action ventures outside of this 95% will be a rare occurrence. The norm wants these prices will quickly return within the bands.
How to Use Bollinger Bands to Improve Your Trading Strategy?
Buy/sell when prices are outside the bands
Bollinger Bands are a volatility indicator that you can use in several ways. Let’s say that you rely on the assumption that 95% of all prices should be inside the Bollinger Bands. One strategy could be to buy when prices are below the lower band and sell when they are above the upper band.
When prices are outside the bands, it represents an extreme situation where market prices are unusually volatile. The probability that prices will return back inside the band is strong. As you can see on the above chart, it’s often a spike in volatility that pushes prices out of the bands.The wicks or shadows of the candlesticks represent the volatility.
do not automatically buy/sell when prices are not within the bands
Prices outside the Bollinger bands don’t automatically mean that prices will reverse.It can sometimes mean that it is just the beginning of a strong trend. Remember that it’s best to trade with the trend. As the markets are always right, you might face huge losses by being against the trend. An uptrend is when prices form higher peaks and higher troughs. Conversely, a downward trend is defined when prices form lower peaks and lower troughs. As you can see on the above chart, prices going outside the lower band are just the beginning of a strong bearish trend on the EUR/USD currency pair.
Use Bollinger Bands Squeeze to Anticipate Greater Volatility and Price Accelerations
Another use of the bands is to identify times when volatility is low – also called the Bollinger Band Squeeze. This usually happens before a moment of high market volatility. When prices do not move much, the band tends to narrow. You will often see this kind of situation when the market is expecting important news like a central bank decision. When the decision is revealed, volatility increases and the bands widen soon thereafter. Take advantage of tight bands, as they generally mean greater future volatility- see the black arrows on the above chart.
Pullback to the SMA
You can see on the above chart another strategy you can use with Bollinger Bands. After you determine the main trend, you can wait for the price to go back to the middle of the bands. Once there, you can open a position in the direction of the trend. You can increase the likelihood of making profitable trades if you wait for the price to test the mid-band before entering the markets within the primary trend’s direction with a large amount of volatility.
Trade The Range
Remember that there 3 main kinds of trends: upward, downward and “lateral”, whereby the asset is trading in a range.For this strategy to work, you need to find first an asset that is trading within such a range. The bands indicate when the selected financial asset has reached the range limit. You can then sell the asset when it tests the upper band, as well as conversely, of course. You will only be taking advantage of small changes in price, but it will help you secure some gains.
Bollinger Bands, Indicators And Chart Patterns
Bollinger Bands and RSI
As we said earlier, when volatility increases the bands widen. Conversely, when markets are quieter, the bands contract closer toward prices. Overbought and oversold situations can be spotted with Bollinger Bands.When prices are on (or above) the upper band, this can mean that the asset is overbought. When prices are on (or below) the lower band, then the asset is said to be oversold and prices can reverse.
The RSI also allows you to spot these extreme situations. The RSI indicates that an asset has reached an overbought level when the value of the indicator is above 70. When the RSI reading is below 30, it shows an oversold level.While using both indicators, signals are confirmed when both indicators signal extreme overbought/oversold situations, as on the chart below.
Bollinger Bands And Candlestick Patterns
Bollinger Bands signals can also be confirmed by candlestick patterns. Among the most important chart patterns are indecision, reversal and continuation patterns. These patterns will definitely help you to fine-tune your entry/exit strategy – especially if they occur on or outside the bands.
In choosing an indicator for your trading strategy, remember to always determine first your aversion to risk and your trader profile. This work will definitely help you better shape your own decision process. It’s always hard for a trader to know when to buy or to sell an asset. Bollinger Bands can help you decide when to make your move. These bands will tell you when the markets are volatile, as well as if they are over or under-valued.
Do you use Bollinger Bands in your trading? If yes, are they the only tool you use, or do you use them in combination with other indicators? Share your trading experience with us: leave a comment!
The Smart Investor content is intended to be used and must be used for informational purposes only. We are not an investment advisor and you should NOT rely on this information to make investment decisions.