Developed by John Bollinger in the 1980’s, Bollinger Bands® is a technical analysis tool which comprises of two price channels (upper and lower bands) plotted two standard deviations (used to measure volatility) away from a moving average (the median line). Despite a decade since Bollinger bands was developed, it is still widely used amongst traders and market technicians to identify volatility and trends in the markets and can be used across different time frames.
Bollinger Bands® are part of the standard technical analysis tools available by default and for free in most trading platforms. Also referred to as Bands, this technical analysis tool is used across various markets including Forex, Stocks and commodities. In this article, we’ll take a look at Bollinger Bands® and how to implement them on the charts.
Constructing the Bollinger Bands®
While today’s trading platforms pretty much do the calculation to display Bollinger Bands®, it is important for the trader to have a fair idea on the construction of Bollinger Bands®.
Bands, typically comprise of three lines. The Center line is an exponential moving average applied to the closing price and the outer bands (or price channels) are placed ideally 2 standard deviations away from this center line.
The outer bands are referred to as price targets. When price trades close to the upper or lower bands, it is inferred that the market is either overbought or oversold. The moving average on the other hand represents the state of trend in the markets. However, trading with Bollinger Bands® is not as simple as selling when price is near the upper band or buying when price is close to the lower band.
If you notice well enough, bands also tend to move in an upward or downward slopes indicating the prevailing trend.
The Bollinger Squeeze and Expansion
You might well know that price tends to be either in a trending state or in a consolidation phase. This same phenomenon can be well seen by the Bollinger Band Squeeze and Expansions.
A Bollinger Band® squeeze represents the consolidation phase and usually occurs just before a Bollinger Band® expansion or the start of a trend.
Traders usually pay attention to these phases in Bollinger Bands® in order to ascertain BUY or SELL trades. It is important to note that when trading with Bollinger Bands®, attention must be paid to both the upper and lower bands.
Trading Strategies – Bollinger Bands®
There are many different kinds of trading strategies involving Bollinger Bands®. While some strategies make use of combining other indicators such as RSI or Stochastics to confirm the trade signals, there are equally popular Bollinger Band® strategies that involve making use of two sets of Bollinger Bands®. Depending on the markets, take profits are usually set to the median line or moving average.
Bollinger Bands® – Summary
- Developed by John Bollinger in the 1980’s and referred to as Bands for short.
- Bollinger Bands® comprises of a 20 day moving average and two outer bands, set up 2 standard deviations from the moving average.
- Bollinger Bands® is used to identify volatility in the markets. Thus, lower volatility or consolidation phase is marked usually by a Bollinger Squeeze (where both the upper/lower bands tend to come closer) and high volatility or trending markets is represented by a Bollinger Band expansion.
- Bollinger Bands® makes for a good technical analysis indicator that shows the trader trending and ranging markets
To conclude, traders should note that while most of the text on the Internet states a BUY at lower band and SELL at upper band, there is a lot of confusion in this regards. A contrary school of thought indicates that price tends to move within the upper and lower bands 75% of the time.
Traders should understand that price can do any of the following.
- Reverse near the upper or lower band and travel all the way to the opposite end or stall near the mid band and reverse back
- Price can break out from either the upper or lower band and continue in that trend for a prolonged period of time
- Bollinger Bands are best known for patterns such as Double Top and Double Bottom, along with the well known reversal patterns such as ‘M’ tops and ‘W’ bottoms also known as Merrill’s Patterns.