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What are Bollinger Bands?
“Bollinger Bands” is a technical indicator developed by John Bollinger in the early 1980s. Technical Analysts use Bollinger Bands to identify overbought and oversold conditions in the market. This indicator consists of 3 bands. The middle band is a simple moving average of 20 days and an upper and lower band. the upper and lower bands are based on the standard deviation of prices and the volatility.
When volatility in the price of an asset increases the bands automatically widen and when volatility decreases, they contract. The upper and lower bands are generally 2 standard deviations plotted positively and negatively away from a 20-day simple moving average but can be modified. These Bands also act as possible Support and Resistance areas.
Calculation of Bollinger Bands
Formulae:-
Middle Band – 20-day Simple Moving Average
Upper Band – 20-day Simple Moving Average +(20-day standard deviation of price x 2)
Lower Band – 20-day Simple Moving Average -(20-day standard deviation of price x 2)
Importance of Bollinger Bands
Bollinger Bands If used correctly can provide valuable insights regarding the Volatility of the price. Many traders believe the closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market. When using Bollinger bands as a trading system one should keep in mind the set of 22 rules provided by John Bollinger.
In my opinion, Bollinger Bands provides the best result when used in a larger trading system. When combined with other indicators such as RSI MACD and Price action it can provide effective trading signals. Bollinger bands can add a layer of understanding regarding the volatility of the price. Bollinger Bands is also a great tool to assess whether the market is in a low volatility zone. and can help a trader identify potential high-volatility periods.
How To use Bollinger Bands?
The most popular method of Using Bollinger Bands is the “Overbought and Oversold Strategy”. However in my opinion using the bands to identify overbought and oversold conditions can be misleading sometimes. In my opinion, Bollinger bands should be used to identify the strength and the momentum of the trend.
Here is a Bollinger Bands Trading Strategy for Day traders
Trading Trends with Bollinger Bands
Bollinger band can help assess how strong the current trend of the market is and whether it is losing its strength or not. This information can be used to make trading decisions.
- When the price is in a strong uptrend, It touches the upper band regularly while forming higher highs. if it is failing to do so, It might be an indication of weakness in the trend.
- During a pullback in an uptrend price stalls near or above the middle band. If it is failing to do so and continuously makes lows below the middle line, It can be a sign of a possible trend reversal. Traders should avoid taking up long positions during these types of formations.
- When the price is in a downtrend, it touches the lower band regularly while forming lower lows. If it is failing to do so. It might be a sign of a weakness in the trend or a possible reversal in the trend.
- When the price is in a strong downtrend, it shouldn’t touch the upper band. If it does, that’s a sign of a reversal.
Spotting Trend reversals with Bollinger Bands
- When the price is in a strong Uptrend, and hitting the upper band consistently and not the lower band, in that case when the price hits the lower band it could signal that a reversal has started. If the price goes up again it is likely that it will not reach the recent price high
- If the price is in a downtrend, and hits the lower band consistently and not the upper band, when the price hits the upper band it could signal that a reversal has started. Now If the price declines again, it is likely that it won’t be able to reach the recent price low.
Summary
Bollinger bands is one of the most commonly used technical indicators, and like any other Indicator, it has flaws. However when used in the correct manner with other technical indicators, In a border trading system It can provide insightful understanding regarding the conditions of the market. Having an understanding of Bollinger Bands Indicator can help a trader enhance their trading setup.
There are multiple uses of Bollinger Bands indicator. But it all depends on the trading style and trading psychology of the trader. It may work for some and for some it may produce mixed or no result at all. A trader should understand how it works and how it can fit into a trading system before trading with it.
