As traders, we watch the markets for any kind of regularity or irregularity. The goal of doing so is to cut down on losses and take advantage of market discrepancies. When it comes to identifying buy and sell channels as well as measuring market volatility, you need an indicator like the Bollinger Bands.
What are Bollinger Bands?
This is an intuitive indicator that helps to show when a pair has been over-sold or overbought. It helps to provide a benchmark for price highs and lows. As a result, it reveals the statistical perspective on the price movement of a security. The powerful technical analysis indicator was developed by John Bollinger, a famous technical trader in the 80’s.
According to the 22 rules of Bollinger Bands, the traditional Bollinger Bands are based on the simple moving average. The reason why the simple moving average acts as a base is because it’s used in calculating standard deviation.
Today, it is available on most charting packages and can be applied not only on commodities and stocks but on forex too. Why? It is able to convey useful information such as volatility, high/low price changes and emerging trend.
The technical analysis indicator is composed of three sections namely:
Upper and lower bands
Central moving average
i. Central moving average
Also referred to as the main line, it is the moving average of the price. Calculations are done the same as a simple moving average finally displaying a smooth version of the price. As a result, it helps to provide a broad view of the market.
ii. Upper and lower bands
John Bollinger incorporated the upper band to extend the idea of the moving average. This is calculated by adding X standard deviations to the moving average. For instance, if the indicator will be using X=2 standard deviations, then the upper band will be said to be 2 standard deviations above the main line. To calculate the lower band, simply deduct the x standard deviations from the middle band.
iii. The Bandwidth
This is defined as the distance between upper and lower bands. As a measure of volatility, the more unstable the price is, the greater the bandwidth. How? The Bandwidth is dependent on standard deviation which is basically an indicator that displays how the price has deviated from the average.
Bollinger Bands Double Bottoms
A Double Bottoms formation is characterized by a sharp price pull back and volume which occurs off the lower Bollinger band. Such movement leads to what technicians call an automatic rally.
What you ought to know is that a high automatic rally serves as the first resistance level which only happens right before the value of a stock increases. When the automatic rally is initiated, the value of the security (price) will retest the current lows in regards to buying pressure.
It is common for technical analysts to retest bar prints located inside the lower band. This helps to show when the security’s downward pressure has reduced. As a result, it reveals a major event – shift from sellers to buyers. For this strategy to be effective, a sharp decline in volume is needed.
Riding the Bands
In this strategy, technicians use the bands as a trend detection tool. When the market is experiencing strong trend moves, the candle sticks will most likely stick to the upper or lower band.
To a trader, this confirms the formation of a trend and the probability that it will continue. John Bollinger himself referred to a tag of the band as a move that touches the bands. While this is not a signal, it helps to signify a weakening or strengthening market.
This can be explained better using Rule No.8 from the 22 Rules of Bollinger Bands.
“Tags of the bands are just that, tags not signals. 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 and of itself a buy signal.”
In regards to Riding the Bands, John Bollinger explained that touching the upper or lower bands is not an indication of buying or selling. When a security is Riding the Bands, the middle band acts as an indicator for an emerging support area especially during pullbacks. As a trader, you have the option of increasing your position during a price pullback towards the middle band.
A clear indication that you should scale down or exit a trade is when a security fails to accelerate outside the bands. This indicates the weakening strength of a security.
Bollinger Bands Squeeze
According to Rule No.19 from the 22 Rules of Bollinger Bands, “BandWidth has many uses. Its most popular use is to identify “The Squeeze”, but is also useful in identifying trend changes…” The strategy above is used when price movement contracts to a thin range. As a result, the Bollinger Bands are forced to squeeze together. Due to the narrowing range, it will result in sharp price movement.
What you ought to know is that a signal is generated when a full candle completes below or above the moving average. In addition, it may be generated when the bands narrow within 10 points. All in all, Bollinger Bands Squeeze strategy acts as a valuable indicator that predicts the possibility of volatility.
If there is a drop in volatility, it means a larger price movement is imminent.
While Bollinger Bands has its flaws, it helps traders and technical analysts to spot potential reversals and trends. Before using the indicator on live trades, test it on available historical data. Remember, Bollinger Bands is a not a trading strategy but it can be combined with one to give you the desired trading results.