Technical Analysis Basics: A Beginner's Guide to Bollinger Bands

Technical Analysis Basics: A Beginner's Guide to Bollinger Bands

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Serving as a visually pleasing and effective technical indicator, Bollinger Bands is a household name among technical analysts. Created by a gentleman named John Bollinger in the early 1980s, the indicator’s primary function is to help evaluate volatility and price action. As many know, there are two predominant methods of evaluating volatility in the financial markets: standard deviation, which represents a measure of spread around a central tendency (mean value), and the use of the ATR indicator (Average True Range). The Bollinger Bands indicator employs the use of standard deviation. 

What is the Bollinger Bands Indicator?

The Bollinger Bands indicator is constructed through three bands, applied over the price action of a chart’s security. The indicator is made up of a central band, usually calculated by way of a default 20-period simple moving average (SMA), and two outer bands (one below the SMA and one above it), which tend to be placed using standard deviation (the default standard deviation is set to two). To add some context, approximately 95% of the price data will be within two standard deviations of the mean value; that is, assuming prices are normally distributed, which they are not. So, it is generally accepted that two standard deviations in the markets equate to around a 90% confidence band. The logic is that when price action surpasses two standard deviations, there’s a good chance of either the market breaking out and pushing further or reverting to the mean (the price could recoil back to the average value of the indicator – the 20-period SMA).

One of the great things about the Bollinger Bands indicator is its versatility. It can be used across all financial markets, including major asset classes, such as foreign exchange (Forex), Indices, Shares, Commodities as well as Digital Currencies (Crypto). Additionally, the indicator can be applied across all timeframes, from short-term periods, like the 1-minute and 5-minute charts to longer-term timeframes, such as the H4, daily and even monthly periods. 

Used to measure volatility, Bollinger Bands answer a simple question: Is the price of the chosen market trading high or low relative to its average price? 

How do Traders Use the Bollinger Bands Indicator?

Bollinger Bands Trading Strategies:

The first and most straightforward way of applying and trading using the Bollinger Bands is by monitoring the distance, or spread, of the outer bands. This is often referred to as the Bollinger Band Squeeze, which is essentially a basic breakout strategy. As can be seen from the chart below, traders attempt to identify periods of low volatility in which the bands squeeze together. This can forecast an expansion in volatility and can be something a trader takes advantage of following a breakout of either the upper or lower band. 

You may also experience price action walking up or down the bands following a breakout. Bollinger notes in his rules: ‘In trending markets, price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band.’ The chart below shows an example of price walking up the upper band in the first situation.

A trading strategy that is always in the market—meaning one that is either long (buy) or short (sell)—can also be used with Bollinger Bands. For example, traders enter long upon identifying a price close above the upper band and liquidate that position to enter a short upon a close below the lower band. Traders, therefore, tend to position protective stop-loss orders beyond the opposite extreme band (and move the stop according to the band if price moves in favour, similar to a trailing stop). For instance, a long position would have traders place a stop-loss order below the lower band. 

Below, you can see many potential shorting opportunities and one long opportunity using this method. If a trader were short in March, they would have held that position until the long opportunity presented itself in November.

It is important to understand that while the outer bands can be considered dynamic support and resistance, context is vital and should be taken into consideration before a trade is taken. Take note that Bollinger highlighted the following in his rules concerning this:

 ‘Tags of the bands are just that, tags do not signal. A tag of the upper Bollinger Band is NOT in and of itself a sell signal. A tag of the lower Bollinger Band is NOT in and of itself a buy signal’. 

Like all technical indicators, professional traders seldom rely on one indicator to trade successfully. It is recommended to combine a handful of indicators that measure different aspects of price movement (volatility, momentum and volume, for example) in addition to traditional price action analysis and fundamental analysis, as underlined by Bollinger. As an example, some traders employ trend identification indicators (something like the Average Directional Index [ADX]) and look to trade/fade the outer bands in line with the trend. Another combination may be to include a momentum oscillator to seek overbought and oversold conditions (and divergence), like the Relative Strength Index (RSI), alongside the Bollinger Bands.

You can see from the example below that there was an opportunity to short the EUR/USD currency pair using a combination of price trending lower, price testing the upper Bollinger Band and the RSI showing negative (hidden) divergence. 

Explore the Bollinger Bands Indicator with FP Markets

While this article has hopefully opened the door to one of the most popular and useful technical analysis tools available today, it is now time to consider test-driving the Bollinger Bands on one of FP Markets’ trading platforms, including MetaTrader 4 (MT4), cTrader, or TradingView

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