John Bollinger is obvious the brain behind the Bollinger Bands, a technical tool that is used to gauge market volatility.
This little tool will give you information on whether the market is quiet or whether the market is loud.
The market is said to be quiet when the Bollinger Bands squeeze and it is said to be loud, when the Bollinger Bands widen.
The active nature of the Bollinger Bands also implies they can be deployed on varying assets using its default settings.
The Bollinger Bands indicator is made up of a middle band along with two outer bands.
The middle band is purely a simple moving average set to a default 2 periods.
The use of a simple moving average is as a result of same being used in the standard deviation formula.
The standard deviation has the same look-back period like those seen on the simple moving average.
Setting the outer bands to a value of 2 standard deviations above and below the middle band is the indicator’s default parameter.
These settings are adjustable, meaning they can be tweaked to suit the features of a specified asset class.
Bollinger endorses carryout light incremental modifications to the standard deviation multiplier.
Altering the number of periods allocated to the moving average also upsets the number of periods used in computing the standard deviation.
This implies that only minute alterations are necessary for the standard deviation multiplier.
A surge in the moving average period would spontaneously surge the number of periods used to compute the standard deviation and would also cause a surge in the standard deviation multiplier.
The Bollinger Bands is represented using the following formula:
* Middle Band = 20-day simple moving average (SMA)
* Upper Band = 20-day SMA + (20-day standard deviation of price x 2)
* Lower Band = 20-day SMA – (20-day standard deviation of price x 2)
Fig. 1.0
Price is said to be overbought when an underlying asset price moves outside the upper Bollinger band, a move that indicates that price is about to reverse from its bullish signal.
On the contrary, when an underlying asset price moves below the lower Bollinger band, it is tagged an oversold condition, as such price is said to be pressured upwards.
Just in case the price of the underlying asset bounces off the lower band on its way up, the middle band would offer the asset’s first resistance, while sustained price push above the middle band would push price towards the upper band.
Just in case price dips lower from the upper band, its first support on its way down could be the middle band, if the bands gets broken, the lower band would be the next level to watch.
Understanding Basic Bollinger Band Signals
There are numerous listed Bollinger Bands trading strategies and the versatility of the indicator is such that you can modify your trading to fit a range of trading approaches.
To top things up, Bollinger Bands come reloaded as one of standard tools in MetaTrader 4.
1. The Bollinger Recoil
One of the things you should be aware of the Bollinger Bands is that price have a tendency to rebound to the middle of the bands.
This concept tells the entire story behind the “Bollinger Recoil”.
If you have a Bollinger Bands added to the trading charts, just looking at the chart only will offer you credible information of what price will do next.
If price reaches the top of the Bollinger Band, it is most likely that it’ll go down – to settle towards the middle area of the bands.
These Bollinger Recoils are known to occur because Bollinger Bands act like active support and resistance levels.
These bands tend to be stronger with longer time frames.
As such, we have seen a lot of currency traders who have adapted their trading strategies to thrive on these recoils and such strategies are best deployed when the market is ranging, with no clear trend in sight.
2. Bollinger Band Squeeze
The Bollinger Band Squeeze is well adapted to trending markets, and is quite self-explanatory.
When the Bollinger Bands squeezes, it is an indication of an imminent breakout.
The move will basically continue in its upward trend, if the candles starts to breakout above the upper outer band.
On the other hand, the move will continue in its downtrend, if the candles starts to breakout below the lower outer band.
Fig. 1.1
Looking at the chart on Fig. 1.1, you’ll notice the bands squeezing together.
Price has also started to break out of the lower out band.
Based on this information, we know that price will head to the downside as the Bollinger Bands squeeze widens.
A typical Bollinger Squeeze is known to function in this manner.
Setups of this type are known to be infrequent and are thus used to catch early market moves.
Problems with Bollinger Bands
The Bollinger Bands performs poorly when in isolation.
John Bollinger endorses that the indicator be used with two or more unrelated technical indicators.
With proven recommendations on how to apply the Bollinger Bands, deploy settings for the indicator that make it easy to adopt such recommendations on a particular asset.
Modify the settings along the way as you try them out on historical charts to see how things will play out.
Keep modifying the settings on the Bollinger Bands until you get one that is tradeable or avoid using the indicator to trade on a particular asset if they don’t seem to help.
Ideally, the settings on the Bollinger Bands vary from market to market, and may require modifications over a period even with the same tradeable asset.
Bollinger Bands trading strategies for scalpers
The Bollinger Bands is a favorite among scalpers due to its ability to adapt to changing market volatility.
It is possible to apply the Bollinger Bands (default setting) on the 5-minute chart along with the Parabolic SAR indicator (step 0.01).
This setup has a good potential for profits and entries for buy/sell are as follows:
Buy Signal:
Strong bullish signal is triggered when price closes above the upper outer Bollinger Band and when the Parabolic SAR forms a dotted line below price bars.
Sell Signal:
Strong bearish signal is in the offing when price closes below the lower outer Bollinger Band and when the Parabolic SAR forms a dotted line above price bars.
We have an awesome scalping strategy dedicated to Bollinger Bands here.
Bollinger Bands trading strategies for day traders
John Bollinger himself suggest that when “Day Trading” you should shorten the number of bars deployed for moving average.
The setting of 9-12 was suggested, but my favorite setting is 12. A standard deviation setting of 2 is applied as well.
While a lot of charting software comes with the standard settings for the Bollinger Bands i.e. 20 for the moving average and 2 for the standard deviation, my preferred setting will likewise try to scan the market for uptrend (when price continuously touches the upper outer Bollinger Band, while pointing nicely up).
A downtrend is said to be in focus, when price continuously touches the lower outer Bollinger band.
Checkout this amazing example of a Bollinger Bands day trading strategy.
Bollinger Bands trading strategies for swing traders
The Bollinger Bands also offers traders swing trading opportunities.
We would combine the Bollinger Bands and the ADX in formulating a swing trading strategy.
If price is seen above the upper Bollinger band, checkout the ADX indicator if it is dipping below the 40 level, then it is a trigger to go short.
Set your short-term targets at the middle line of the Bollinger Bands and further down towards the lower outer Bollinger Band.
Checkout here a nice working swing trading strategy with Bollinger Bands.
For more swing trading strategies with Bollinger Bands and other technical indicators, click here.
Conclusion
Bollinger Bands are splendid at showing volatility. It is easy to notice the bands as the contract or come close.
This implies that the market has become quiet. The forecast usually is that calm goes before the storm.
This suggests that the market is gaining steam to start moving.
Once Bollinger Bands are seen to contract, then breakouts is imminent and traders should get ready for profit taking.
It is possible to determine whether prices are comparatively high or low, the Bollinger Bands are said to hold 88-89% of price action.
From a technical point of view, prices are said to be quite high when above the upper band and quite low when below the lower band.
Nevertheless, quite high should not be mistaken for bearish or a sell alert. Similarly, quite low should not be termed bullish or a buy alert.
Prices in the market will normally get really high or low for a reason.
Just as with other indicators, the Bollinger Bands should not be deployed as an isolated technical tool.
Technical analysts should be able to mix the Bollinger Bands with basic trend analysis, along with other indicators that provide directional signals.
Finally the Bollinger Bands indicator is just a tool, you must know how to use it to get the best out of it.