Bollinger Bands is a chart indicator that was created by American financial analyst John Bollinger in the 1980s. It is used in technical analysis by investors in order to measure the volatility of the financial instruments, and help predict potential market trends and investment opportunities.
How Bollinger Bands Work
The indicator is comprised of a centre line, which is an exponential moving average, and two price bands, above and below the centre line, which are standard deviations of the financial asset being charted.
When the asset is experiencing low volatility, the bands contract, with the price moving along the channel created, in a tight trading pattern. Conversely, during moments of high volatility, the bands will expand to indicate this change in the market, with the asset’s price breaking above or below previous periods of consolidation. Traders can learn how to read Bollinger Bands to assess the volatility of the market, or to take advantage of potential trends that are forming, as in the cases of the Bollinger Bounce and the Bollinger Squeeze.
The Bollinger Bounce
During times of low volatility, an asset’s price will usually return to the centre of the two bands. In these instances, the bands act like dynamic support and resistance levels that the asset price rebounds off of. This action is known as the Bollinger Bounce. When the asset price reaches the upper band, investors can place an order to sell, with the expectation that the price will bounce off the band and move back downwards. Conversely, when the price reaches the lower band, traders can open a position to buy, on the prediction that the price will rebound upwards. On the chart below, for example, we would expect investors to sell the asset at points 1 and 3, and place a buy order at points 2 and 4.
The Bollinger Squeeze
The Bollinger Squeeze forms when the upper and lower bands move close together, signalling a potential breakout. If the asset price starts to move above the upper band, a bullish upward movement can be expected, and investors can place a buy order to take advantage of this emerging trend. In comparison, if the price crosses the bottom band, a bearish downward trend can be expected and traders can initiate a sell order. By following the Bollinger Bands closely, market trends can be identified early, providing investors with the chance to make a greater profit. In the example below, we can see the price escaping the upper band, which predictably leads to a significant upwards movement. Traders that identified this trend in its early stages and placed a buy order as soon as the price moved beyond the upper band would have ended up with a tidy profit.
Bollinger Bands is an extremely useful indicator in technical analysis, as its strength lies in measuring the volatility of a market and in identifying potential trends, be they bullish or bearish, that may provide higher chances of success. However, it is not a standalone system, and is best used in conjunction with other indicators that provide more direct signals. John Bollinger himself has suggested the use of Bollinger Bands be supplemented with two or three other indicators such as Moving Average Divergence Convergence (MACD) or Relative Strength Index (RSI), that are based on alternative data types. Doing so can significantly increase an investor’s probability of successfully identifying, and profiting from, impending market trends.
Bollinger Bands Settings
When using Bollinger Bands to conduct chart analysis, there are various settings an investor needs to consider. These include:
- Moving Average
- Price Measurement
- Standard Deviations
The Moving Average refers to the centre line of the Bollinger Band indicator. When applying it to a chart, traders will have to select the length of the Moving Average, which usually defaults to 20. The best setting to use for this parameter will depend on the time-frame an investor is charting, as well as the instrument being traded. John Bollinger, has suggested that, for the best results, a period which sees the moving average frequently acts as a support to the asset price should be selected. He postulates that when a correct length has been selected, the Moving Average will act as a line of support more often than it is broken.
The Price Measurement refers to the chart price that should be used when conducting the calculations needed to create the Bollinger Bands. The default is usually set to the close price, although most trading platforms provide a range of options including the open, high and low prices. Once again, and as with the Moving Average, the best setting to use will vary depending on the time-frame being charted, and the instrument traded.
Investors also have to select the number of Standard Deviations that will be used to calculate the upper and lower bands. If a low number is chosen, the distance between the bands and the asset price will be smaller. Conversely, when a higher number is chosen, the bands will be further away. The default is frequently set to 2, which is what most traders start with. You can then increase or decrease the Standard Deviations by small increments until you identify the best setting for you.
When using Bollinger Bands for Forex trading, or the trading of any other financial instrument, the settings chosen are important, as they will affect the accuracy of the data the indicator provides. As mentioned previously, the best settings for the various parameters of the Bollinger Bands will differ from trader to trader and, as such, some adjustments may be required in order to find the settings that provide the best results for you.
Bollinger Bands in Real Trading Conditions
Having covered the basics about this indicator, how it works and the various settings needed to apply it to a chart, let’s take a look at how to use Bollinger Bands in real trading conditions. Below you can see a chart of the EUR/USD currency pair, between March and July of 2016.
The pair has been charted at a daily time-frame, and the Bollinger Bands indicator has been set with default parameters (MA: 20, PM: Close, SD: 2). As we can observe in the highlighted area, the asset price moved between the upper and lower bands throughout the period, frequently demonstrating the Bollinger Bounce. When the price reached the upper band, it often rebounded downwards, and upon reaching the lower band, it tended to move back up.
Looking at the same chart between June and November 2016, we can see a clear example of the Bollinger Squeeze. As shown, the upper and lower bands first begin to contract, indicating an impending breakout. The asset price then crosses the bottom band before experiencing a significant price drop. Investors that had identified this trend early, through the use of sound technical analysis, could have netted a tidy profit from this movement.
As we have seen, the Bollinger Bands chart indicator can prove to be an immensely useful technical analysis tool for investors to assess market volatility and identify potential trends. It provides accurate interpretations for a range of assets including Forex and Shares, and is a good tool for daily chart traders and those interested in alternative time-frames. Though it is a simple enough indicator to use and understand (and for those that struggle, a comprehensive tutorial shouldn’t be difficult to find), traders must remember that it is not a standalone tool. Bollinger Bands should be used concurrently with other indicators that provide more direct signals. Furthermore, although tools are an asset to any trader, they shouldn’t be overly relied upon. Instead, they should be supplementary to a good understanding of the markets, a well-developed trading strategy and sound risk management.