One of the most often used technical analysis indicators by traders is the Bollinger Band. Developed by John Bollinger in the 1980s, Bollinger Bands provide a volatility envelope around the price of an asset, allowing traders to identify periods when prices are running too high or too low relative to recent price action. This makes Bollinger Bands a useful tool for identifying potential support and resistance levels as well as highlighting periods where a reversal may occur.
Keep reading to learn what Bollinger Bands are, how to read them, and some effective strategies for incorporating them into your trading approach.
What are Bollinger Bands?
Bollinger Bands consist of a simple moving average (SMA) of typical price surrounded by an upper and lower band. The SMA acts as the middle band while the upper and lower bands are plotted at a specified number of standard deviations above and below the SMA.
The standard deviation, which measures volatility, defaults to two but can be adjusted if required. Narrower bands indicate lower recent volatility, while wider bands suggest higher volatility. Bollinger Bands provides a relative definition of high and low that adjusts to the degree of market volatility.
When the price touches or exceeds the upper band, it signals the asset may be overbought. Contrarily, when the price touches the lower band it could indicate an oversold market. Breakouts beyond the normal band levels often foreshadow a continuation of the prevailing trend or a potential reversal back within the typical trading range.
Most traders use a 20-period SMA as their middle band with two standard deviation bands above and below. However, Bollinger Band periods can be customized and optimized for each market and time frame being analyzed. Shorter lengths are used for faster-moving or more volatile markets, while longer periods smooth price action over time on slower ones.
How to Read Bollinger Bands
While Using The Allpips trading platform you can adjust the Bollinger Bands period, shift, and the colors of the bands and background. You can easily do that by following the steps in the picture below:
Now that you understand the basics of what Bollinger Bands represent, let’s examine the key signals traders watch for in their behavior:
– Squeeze/expansion: When the bands contract and volatility decreases, look for an expansion as movement picks up.
– Touches: Price bounces off the upper/lower bands often providing trading opportunities as momentum reverses temporarily.
– Pin bar rejection: A long lower shadow rejecting from the lower band signals support, potentially marking a bottom.
– Divergence: When bands diverge from the price action, it can warn of a pending trend change.
– Breakouts: Strong moves beyond the normal band levels often precede continuation of the existing trend.
– Crossovers: When the price line crosses above or below the middle SMA band, it indicates shifting momentum.
Understanding how these common formations and behaviors provide insights into market internal momentum is key to effective pattern recognition. Let’s now cover how to put those readings to use.
How to Use Bollinger Bands
Here are some more details on how to use Bollinger Bands effectively:
Determine the Settings
The default settings of 20 periods and 2 standard deviations usually work well, but test different combinations for your asset. Shorter periods suit more volatile assets. Wider bands provide stronger signals at the expense of more whipsaws.
Use Multiple Timeframes
Review bands on lower and higher timeframes for confluence – e.g. daily and 4-hour. Look for signals aligned across timeframes for increased reliability.
Combine with Other Indicators
Pair bands with moving averages, RSI, or stochastic to combine momentum and range analysis. Only trade signals that satisfy multiple indicators’ criteria.
Consider Candlestick Patterns
Look for pins, hammers, or engulfing candles after bounces off bands. These refine entries and confirm momentum reversals.
Set Price Targets and Stops
For range trades, target a full retracement or break of the opposite band. For trends, trail stops as prices run. Exit if stops are breached to limit losses.
Be Disciplined
Only trade high-probability setups as per your strategy. Don’t chase moves beyond bands. Strict risk management helps you stay in the game long-term.
Backtest Strategies
Vary settings and strategies on historical data to find an edge. Monitor performance across market conditions before risking capital on life trades.
Monitor Consistently
Review bands daily and seize opportunities as they arise according to your plan. Be nimble but let trades develop fully before entering.
Bollinger Bands Trading Strategies
Bollinger Bands are useful for a variety of strategies. Here are a few effective tactics:
Range Trading
One of the most common Bollinger Bands strategies is to scalp bounces between the upper and lower bands. This aims to capitalize on the market contracting and expanding volatility within the dynamic trading range formed by the bands. Positions are initiated on touches or crosses of either band, with targets of a full retracement back to the other band. Tight stops are utilized to limit potential losses from false range breaks.
Mean Reversion Trades
When sharp price spikes thrust the asset outside of the Bollinger Bands, traders will look for a mean reversion back within the bands. As the bands tighten again and regain their function as dynamic support and resistance, entry orders can be placed in the direction of the reversion anticipating prices will not sustain at extreme levels for long. This tactic assumes prices gravitate back to the typical price channel over time.
Trend Trading
For trending markets, breakouts through the upper or lower threshold of the normal Bollinger Bands can be traded. Since sustained breaks are more likely to precede trend extensions than reversals, entries follow the breakout flow aiming to ride the trending move. Stops are traditionally placed on the close of a reversed band cross to limit potential downside from false signals.
Counter-Trend Plays
Even in strongly trending environments, short-term counter-trend moves against the larger prevailing direction are common. These occasionally whipsaw, offering reversals back in line with the underlying trend. Traders watch for divergences between price action and shifting band levels near support/resistance for cues to enter counter-trend positions. Strictly limiting trade duration to a few periods helps manage risk.
Multiple Timeframe Analysis
Analyzing Bollinger Bands across different timeframes can reveal confluence zones of high probability. When short-term bands begin to touch resistance/support formed by longer-term band levels, traders take note, as confirmation of a bounce/break may be imminent. Strategies become more robust layering signals identified on various periodicities.
Advanced techniques incorporate Bollinger Bands with oscillators, adaptive expansion bands based on ATR, Fibonacci levels, and patterns, or customized composites of multiple tools. Ongoing testing, optimization, and discipline with position sizing/risk controls are key prerequisites for longer-term Bollinger Bands strategy profitability.
Conclusion
In summary, Bollinger Bands provides an intuitive way for traders to identify periods of higher and lower relative price volatility, acting as a dynamic resistance and support channel.
Their integration as part of a complete system emphasizes trend strength, reversal signs, and trading range behavior across all markets and timeframes. Proper testing and verification affirm their widely proven value for filtering out market noise and generating high-probability trade plans. Over the long run, those simply taking opportunities evident from Bollinger Bands have benefited from John Bollinger’s profound contribution to technical analysis.
