Bollinger Bands – Introduction
Bollinger Bands are a type of technical indicator developed and copyrighted by world renown technical trader John Bollinger in the 1980s.
This tool has found a lot of popularity over the years and can be found on the charts of many technical traders these days!
So what exactly are Bollinger Bands and how can you utilize them as part of your trading toolbox?
We answer those questions and more below, so grab a coffee and enjoy the read!
Bollinger Bands – The Basics
Bollinger Bands consist of 3 lines and help us identify market volatility and potential overbought/oversold levels.
At this point, you might be wondering what exactly these three lines represent!
The lines themselves represent two volatility bands set around a moving average.
If you are not familiar with what moving averages are and how they work, make sure to check out this article here before continuing with this post.
The middle band is typically the 20-day moving average. Whereas, the upper and lower bands represent 2 standard deviations above & below the moving average.
Standard deviation is a measure of volatility, therefore, the bands will tell us whether a market is quiet or loud!
When markets become more volatile, the bands expand. Whereas when volatility drops off, the bands will tend to contract.
The idea behind this approach is that the standard deviations cover about 90% of occurrences. This means that price should stay within the bands around 90% of the time. As such, Bollinger Bands can be used to determine if prices are relatively high or low.
If price is near the upper Bollinger Band, the market is considered to be overbought or expensive. Whereas, if price is near the lower Bollinger Band, the market is oversold or cheap.
Let’s take a quick look at an example of this below:
Bollinger Bands – Don’t Make This Mistake!
Something important to note is that in trending conditions, markets tend to “walk the band” and may remain “overbought” or “oversold” for a long period of time.
The single biggest mistake that Bollinger Band newbies makes is to get short when a market touches the upper band. Or get long when it reaches the lower band.
Just remember that price penetration of the bands alone DOES NOT qualify a valid trade signal.
Want proof? Have a look at these examples below:
Crude Oil remains oversold for many months as the market plunges to new lows.
Anybody caught buying the lower bands would get crushed as the market stays oversold for months.
USD/CAD pair remains overbought for many months as the market rips to new highs.
Imagine shorting each touch of the upper bands in this scenario! Might as well say goodbye to your trading account!
Anticipating Breakouts with Bollinger Bands
Volatility in the markets changes from week to week, day to day and even minute over minute.
This can make it difficult for new traders to identify the current volatility within a market.
Professional traders know that contractions in volatility often precede expansions in volatility.
What does this mean? Simply that a market will often consolidate before trending and vice versa. The question now becomes, how do we use Bollinger Bands to anticipate a possible breakout?
Good question! You will want to see a Bollinger Band “squeeze” or contraction as this tells you that the market is in a low volatility environment and may be prone for a breakout.
Check out the examples below for visual references:
Rule of Thumb: The longer the period of volatility contraction, the stronger the subsequent breakout should be!
Although the Bollinger Bands can clue you in on a market ripe for a breakout. They will not tell you the direction in which the breakout will occur!
There is a simple fix to this! You’ll want to look at the overall trend in the market and trade in that direction.
If you see that buyers are in control of the market into the squeeze, a breakout to the upside is more likely to occur. Alternatively, when the sellers are in control leading into the squeeze, a breakout to the downside is more probable.
Trend Trading with Bollinger Bands
Let’s say you miss the breakout that starts a new trend.
Price rockets away but you can’t seem to qualify an entry at these levels.
Where could you look for potential value?
You guessed it…the Bollinger Bands!
The middle line is usually a 20-day moving average. This means that during trending conditions it will often act as a form of dynamic support or resistance for the market.
The outer bands also play a key role as potential trade locations as they imply prices are relatively “cheap” or “expensive” within the trend.
The key to this strategy is to wait for a breakout to occur first and then to target the first pullback for a potential trade back into the direction of the trend.
Let’s look at some examples:
In the Gold chart below, note how the middle and outer lines act as a ceiling as the bearish trend unfolds.
After the bearish move, Gold consolidates for several months and we see the bands start to squeeze together.
The market breaks out above the previous highs and the bull trend looks to be underway.
Bollinger Bands – Trend Trading Bullish Example
After the initial breakout, the market pulls back into the lower band and closes outside of it. The next candle closes back within the lower band and signals the bulls are back in control and the pullback may be over.
The market breaks to fresh highs from here and continues to respect the middle band as support on pullbacks.
Little Tip! If you are buying or selling a pullback to the middle line, you can look to take profit at the outer band.
If you prefer to hold the full position and ride the bands instead, then you can trail your stop using the middle line once it surpass your initial entry.
Anticipating Reversals with Bollinger Bands
Reversal trading tends to work well in a market that is trading within a well-defined range.
Take note of the EURGBP chart below for one such example.
What you’ll notice is that we’ve added some support and resistance lines to identify the boundaries of the range.
Combining S/R with candlestick patterns and Bollinger Bands makes for a very potent reversal strategy! Let’s walk through the example below to clarify.
Bollinger Band – Reversal Example
The market has come off a recent bullish move and is now consolidating within a range.
The extremes of these ranges are the only locations where we are willing to do business. So we sit on our hands until price gets there!
Once the market trades into our level, we want to see a failure. This will come in many different forms but the most common is via a pinbar rejection. To add confluence, the failure wick should trade outside the boundaries of the bands but close back within them
This is the cherry on top and signals that a potential reversal is in play! The initial target in this situation would be the middle line with the secondary target at the outer band.
When the Bollinger Bands Don’t Work?
It would be great if every one of our trades ended up a profit. That’s simply not the case and will never be, so get rid of those thoughts!
Just like with any other strategy, there will be losing trades.
The goal here is to minimize your losses and maximize your gains.
When the Bollinger Bands don’t work, simply cut your losses, review the trade in your journal and move on to the next best opportunity.
Final Thoughts
If you’ve made it this far, you now have the foundational knowledge to implement Bollinger Bands into your trading toolbox.
They are great tools to identify markets that are prone to break out as well as identify value within a trend.
Meanwhile, in ranging market conditions, we rarely see directional follow through so reversals are king during these times!
While not necessary for success, we hold the Bollinger Bands in high regard as a really great tool for the technical trader!
We hope you’ve enjoyed this post and will implement some of the tips moving forward!
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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.
