Another technical analysis tool to have in your toolbox are Bollinger Bands. Immensely popular among traders for their reliable signals, Bollinger Bands can accomplish a number of functions:
- They provide a visual representation of volatility;
- They show the strength of a trend; and
- They reveal whether prices are overbought or oversold on a relative basis.
These signals allow traders to find market tops and bottoms, better time entries and exits and anticipate explosive breakouts and breakdowns.
To decide whether you want to incorporate Bollinger Band strategies in your trading plan, we take you through what Bollinger Bands are, how to read them, and some strategies to explain their usefulness.
What are Bollinger Bands?
Technical trader John Bollinger developed Bollinger Bands in the ’80s as a way to quickly determine whether a stock was overbought (expensive) or oversold (cheap).
The Indicator itself is a simple tool composed of three lines:
- Centreline – A 20-day simple moving average.
- Upper Band – Two standard deviations above the moving average centerline.
- Lower Band – Two standard deviations below the moving average centerline.
However, to grasp the capability of Bollinger Bands, we first need to understand the statistical importance of standard deviations and the concept of normal distribution.
What are Standard Deviations and Why are they Significant?
If you paid attention to statistics at school, feel free to skip ahead. If not, allow us to briefly explain.
You may be familiar with a bell curve. In statistics, the bell curve is a visual representation of ‘normal distribution’. The center of the bell curve will always contain the highest concentration of data points with each side decreasing in value in a symmetrical fashion (giving the characteristic bell-shaped curve). We can use this idea of ‘normal distribution’ to calculate the probability of something happening.
This is where standard deviation comes into play. Standard deviations measure how spread out data points are from the mean or the average value. Where the standard deviation is small, this means that there is less variance in the data with data points dispersed close to the mean. A higher standard deviation means that there is more variance in the data.
Around 68% of all activity in the data should fall within 1 standard deviation of the mean. This increases to 95% within 2 standard deviations and 99% within 3 standard deviations.
When we apply this to the stock market, standard deviation analysis can be used to illustrate market sensitivity. The further away a standard deviation is from the moving average, the higher the volatility in the market. The closer the standard deviation is from the moving average, the lower the volatility. Here, in essence, lies the beauty of Bollinger Bands, they provide an easy visual representation of volatility. One glance at the volatility bands, and you can easily see if the market is overstretched or contracting.
As Bollinger Bands uses 2 standard deviations, we can expect that around 95% of all trading activity should fall in between two standard deviations. Where price moves outside the Bollinger Bands, they are considered outliers. Outliers are significant signals to many traders.
Regression Back To The Mean Theory
Why are outliers significant to traders? Well, there’s this statistical phenomenon called ‘Regression back to the mean’. In nature, the markets, and everyday life, things have a tendency to return to the average.
The ‘Sophomore Slump’ is an example of this theory. In major league baseball, a rookie player that breaks out in their first year will likely have a disappointing second year. In the stock market, a wild bull market will likely end in a major market correction. While markets can swing wildly up and down, it is unusual to stay at extremes. There is always a return to equilibrium.
Bollinger Bands provide an easy way to visualize regression back to the mean. When stock price falls within the upper and lower band, this can be seen as a ‘normal’ price. However, once the stock price falls outside the Bollinger Bands, this is significant. The price is either ‘overbought’ (too high) or ‘oversold’ (too low). More often than not, rather than staying in the overbought or oversold territory, the stock price will return back to the middle line.
How to Calculate Bollinger Bands
You will probably never need to calculate the Bollinger Band lines. All major trading or charting platforms will have the Bollinger Band Indicator in-built. Nevertheless, it is essential to understand the math behind the indicator if you intend on using it to make trading decisions.
The first step is to calculate your middle line. The middle line is a simple moving average that is used to filter price action and show trend. John Bollinger, the Bollinger Band creator, prefers to use a 20 day Simple Moving Average (SMA). You of course can adjust your settings to accommodate your trading strategy. The simple moving average is a basic average calculation.
The next step is to calculate the standard deviation.
How to use Bollinger Bands – Bollinger Band Strategies
Overbought and Oversold – Rubber Band Strategy
In a ranging market, traders can use Bollinger Bands similar to a rubber band. When a stock reaches the upper Bollinger Band, it is considered to be overbought. The expectation is that prices will pull back to the middle. Traders can use this as a signal to sell or as a price target.
When a stock touches the lower band, it is considered to be oversold. Again, the expectation is that stock prices will bounce back up to the middle. Traders can use this as a buy signal or as a place for a stop loss.
However, while probability theory assumes that price will regress back to the mean, this regression may not be instant. Stock can stay overbought or oversold for lengthy periods of time before reverting back. During this time, prices of a stock can continue moving in an up or downtrend. This is why it is a mistake to rely solely on Bollinger Bands for trading signals without taking into account other market factors. Traders are better off taking into consideration Bollinger Bands signals with Support and Resistance, momentum, and candlestick patterns.
Find Breakouts – Bollinger Squeeze
Volatility in the market is always changing. From periods of high volatility to periods of incredibly low volatility. Bollinger Bands provide an easy way to visually represent volatility.
When volatility is high, the area between the upper and lower bands is large. When volatility is low, the area between the upper and lower bands start to contract and narrow. This represents market consolidation or a squeeze. In line with the regression back to the mean theory, when volatility contracts and squeezes to extreme levels, a sharp and price movement is expected. The longer the volatility contraction, the stronger and more explosive the breakout is expected to be.
However, while Bollinger Bands can help alert you to potential breakouts, it doesn’t alert you to the direction of the breakout. The stock could break down. Instead, traders should look for clues in trend, candlestick patterns, and other indicators to determine whether the stock will break up or down.
Bottoms, Tops, and Fakes
Bollinger Bands are flexible enough to be used to identify W-Bottoms, M-Tops, and Head Fakes.
A W-Bottom occurs when the second low is lower than the first low but still holds above the lower Bollinger Band. This happens as bulls react to the first low by raising the price back to the middle. The bears come back in and pull the price back down creating a new price low but holding above the lower band. Where bulls push the price back above the high of the first pullback, this completes the W-Bottom formation and indicates that the price will likely continue to rise. W-Bottoms are a bullish signal.
An M-Top occurs when the second high is higher than the first high but closes below the upper band. Where bears pull the price back down below the first pullback, this confirms a bearish reversal. In this scenario, the bears win this battle.
Another bearish signal to look out for is three high swings with lower highs. This is when the first swing reaches the upper band but the two subsequent swings fail to reach those highs. This shows fading momentum and signals a bearish reversal.
Alternatively, three low pullbacks with higher lows is a signal for a bullish reversal. If the first pullback touches the lower Bollinger Band but the next two swings fail to dip back to the band, the bears are losing momentum.
Best Time Frame For Bollinger Bands
The best time frame setting for Bollinger Bands will depend on your trading style. If you’re a quick scalper, the lower time-frames of 5-minutes or 15-minutes may work better for you. Longer swing traders may be better off using hourly, daily or weekly timeframes. In any case, Bollinger Bands can be used across all different timeframes. The same concepts apply.
Do Bollinger Bands Work?
Bollinger Bands are a great chart analysis tool, especially for visual traders. In a simple glance, traders can monitor the expansion and contraction of volatility in the markets.
Without volatility, there is no opportunity. The more volatility in the marketplace, the greater the opportunity to make and lose money. This makes risk management an even more crucial skill to prioritize. Traders need to learn to keep their losses small while letting their winners run and keeping their emotions in check. As we stress time and time again – you need to have a plan!
Below, we give you a few extra tips so you can get the most out of Bollinger Bands.
Don’t Ignore the Trend
A common mistake when using Bollinger Bands is forgetting about the underlying trend.
Some traders use Bollinger Bands as an immediate signal to buy and sell. For example, when the price touches the upper band, sell. When price touches the lower band, buy. Unfortunately, successful trading isn’t exactly this easy. You still need to take into consideration the overall trend.
Look at your charts, consider price action, look at the news and seek confirmation before entering into a trade.
If you want to limit your risk, don’t take entry signals on a downward trend, and vice versa. Luckily, Bollinger Bands make it easy to spot trend direction. The whole point of the centreline or 20-day simple moving average is to drown out noise to easily identify trend direction. When the band slopes up, there’s an upward trend. When the band slopes down, there’s a downward trend.
During strong trends, the price will hover around the outer bands. If the price starts to pull back towards the middle, this shows falling momentum in the trend. Likewise, repeated swings to the outer bands that fail to reach the band, show a lack of power in the trend.
Better time entries
Timing is incredibly important in trading. One of the biggest drawcards of using Bollinger Bands is the ability to better time your entries and exits.
When price touches or moves below the lower Bollinger Band, wait until the price pushes back and closes above the lower band before entering into a long trade. This slight push up is your form of confirmation that the price is reversing. From there you can use the center or upper line as your profit target or exit points.
Before exiting a trade, wait for confirmation that the trend is over. Does the price move above the upper band before closing below the band?
Of course, always look at price action and use it in combination with support and resistance levels.
Use with Momentum Indicator
Bollinger bands accompanied by a momentum indicator like the Relative Strength Index (RSI), form the foundation of many successful trading setups. The Bollinger Bands provide a great representation of volatility and RSI reveals momentum and strength in the underlying moves. Like the perfect match, they complement each other.
Here’s how to use the two indicators together:
- When the price is hovering around the upper band but is also accompanied by a bearish RSI divergence, this indicates weakness in the upward trend. A bearish reversal is likely imminent as the trend shows weakness.
- When the price is hugging the lower band but is also accompanied by a bullish RSI divergence, this indicates a bullish reversal.
Sometimes, indicators have a tendency to cloud a trader’s judgment. The beauty of Bollinger Bands though is their simplicity. Composed of just three lines, they’re a clean tool that won’t overcomplicate your charts, or distract you from the underlying price action. In our experience, the best, most long-lasting setups are the easiest. Give Bollinger Bands a go and see if it improves your trading performance.
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