Bollinger bands were developed by a well-known technical analyst of the financial market John Bollinger in the early 1980s. Bollinger bands are based on the technique of using moving average with standard deviation channels above and below it. They are made up of a center line and mirroring channels in the either side of the line. Bollinger bands are very effective in assessing price actions.
The concept of the bands was first introduced by an American engineer J.M. Hurst who called his theory “trading envelopes”. Hurst put these envelopes around a stock index with a fixed percentage and suggests that trades can be carried out when the stock reached either end of the envelope and then start reversing. However, John Bollinger, contrary to the popular belief that volatility in the financial market is static, applied a 20-day moving average and added two bands based on standard deviation. Bollinger bands were then named after John Bollinger who developed this technical indicator.
The concept of Bollinger bands is based on market being overbought or oversold. When prices continually touch the upper band, the market is considered overbought, on the other hand, when they continually touch the lower band, the market is considered oversold and hence there is an expectation for price reversal.
Since the introduction of Bollinger bands as a tool for trading, it has become very popular worldwide; most professional traders prefer to use them alone or in combination with another technical tool like Fibonacci levels. The major reason why Bollinger bands have been so much accepted worldwide is that they are so effective in determining the expected price actions. The bands provide information that can lead to profitable trading. There are some features you can find in Bollinger bands that do not exist in other indicators.
Bollinger bands are made up of 3 lines:
Both the upper band and the lower band are based on standard deviation which is a mathematical formula for measuring volatility. It shows how price can vary from its real value; thus by measuring the volatility in the market, Bollinger bands adjust to market conditions. Hence, by using standard deviation we can obtain the value of the three bands as shown in the example further.
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Let’s assume a 4-bar Bollinger band with two standard deviations, and then we assume that the last 4 price closes were: 22.5, 24.0, 23.10 and 24.5.
Calculating the simple moving average, we have:
22.5 + 24.0 + 23.10 + 24.5 = 94.10
94.10/4 = 23.525
Now, we subtract 23.525 from each bar and then square the value:
22.5 – 23.525 = -1.025 Squared= 1.051
24.0 – 23.525 = 0.475 Squared= 0.226
23.10 – 23.525 = -0.425 Squared= 0.181
24.5 – 23.525 = 0.975 Squared= 0.951
We then add the above-calculated values together:
1.051 + 0.226 + 0.181 + 0.951 = 2.409
And divide it by 4:
2.409 / 4 = 0.602
We then get the square root of this value:
?0.602 = 0.776
The upper band will be 23.525 + (2 × 0.776) = 25.077
The middle band will be 23.525
The lower band will be 23.525 – (2 × 0.776) = 21.973
As for their functions, Bollinger upper band and Bollinger lower band are responsible for measurement of deviations while the Bollinger middle band measures intermediate-term price tendency, which is just a simple moving average. The volatility in the market determines the interval between the upper Bollinger band and the lower Bollinger band. One major advantage of using these bands is that they are so effective and strong in locating new trends as they emerge.
When you choose to use Bollinger bands in your trading, you can adjust the standard default parameters, which are usually 20 periods and 2 deviations, to suit your taste.
Bollinger bands are very effective in determining price actions. We take a look at some of the benefits of using Bollinger bands indicator:
When observing the Bollinger bands, they will tighten when the market trades in narrow range, indicating that there is about to be a major breakout soon. They help trader to stay alert and wait for the breakout.
Bollinger bands have both upper and lower bands, when price break above or below one of these bands, it is an indication that there is about to be a breakout and new trend is about to develop. This will enable rational trader to set a trade in the direction of the breakout.
For long-term traders, currency trends last for a long duration of time. Using the Bollinger bands by such traders will enable them to enter at the best risk/reward level. What they need to do is watch out for a dip towards the middle band and then set a trade in the direction of the trend.
In the use of Bollinger bands, when price hits the upper band, it is an indication that the market is “overbought” and thus “a sell” is generated, the price should now begin reversing back to middle band, also if the price hits the bottom band, it indicates that the market is oversold and “a buy” is generated, the price is now expected to start moving up to the middle band.
Bollinger bands are used to know the volatility in the market. A professional trader can spot major moves or breakouts from the bands by mere looking at them, but an amateur trader may find them difficult. Now, when you use Bollinger bands, here is what you should look out for in the bands. The common actions you expect in Bollinger bands are the widening and tightening of the upper and lower bands.
Take a look at the bands, are they getting wider? If the bands are getting wider this means an increase in volatility. Thus, it is an indication of possibility of further moves in the current direction. Now is the time to prepare to enter the market, but don’t just jump in yet – we need to make sure of it first.
When the bands are widening, there are two conditions we are going to look out for. They are called the Bullish Widening Bollinger and the Bearish Widening Bollinger. We will look at these conditions one after another:
Now when the Bollinger bands are widening, we have what we called Bullish Widening Bollinger Bands, which usually takes place after there have been some tightening of the bands when there was low volatility. During this period, there are three conditions that can emerge:
Actions You Need to Take
When the above conditions are met, do the following:
When you have confirmed all of the above conditions, you can now hope for more upward movement. What you will do now is just expect a confirmation by waiting for 2 or 3 more candles to authenticate the trend. When this is confirmed, you can safely take a long position. Note that if the ADX refuse to move above 25, it is an indication that the upward move will be short and thus the profit from the trade will be limited.
Bearish widening Bollinger bands mostly occur when the volatility in the market increased and has caused the bands to widen. It is the opposite of the Bullish Widening Bollinger Bands. When this occurs, there are three conditions you need to look out for:
Actions You Need to Take
When the above conditions are met, do the following:
When you’ve seen the above conditions taking place, you can now hope for further move in downward direction. Now, you can wait for confirmation with 2 or 3 more candles to authenticate the move before you can go ahead and safely put a sell order. Note that if the ADX is not yet above 25, it is an indication that the downward movement will be limited and hence the profit from the trade will be limited.
If the bands are coming together i.e. they are tightening, this is an indication of a decrease in volatility. This usually occurs before a major breakout, something known as the silence before the storm. If you encounter this while using Bollinger bands, it is the best time to analyze the possible direction of the breakout before it finally appears.
Just like in the widening of Bollinger bands, under the tightening of Bollinger bands, we also have two conditions that are called the Bullish Tightening Bollinger Bands and the Bearish Tightening Bollinger Bands.
The bullish tightening Bollinger bands occur when there is less volatility with a prolonged movement sideways (i.e. short candlesticks).
When this occurs, you should take the following actions:
When all the above conditions hold, then we can hope for an upward breakout. Once we know this direction, we wait for 2 or 3 more candles to authenticate this movement before we can go ahead and safely put a buy order.
The bearish tightening Bollinger bands occur during the same general conditions as the bullish tightening, but your market analysis actions should differ:
When all of the above conditions hold, we can now hope for downward breakout. We can now confirm it by waiting for 2 or 3 more candles to signal it before we can safely put a sell order.
Now, during the movement of trends in these conditions, there can be corrections both when the price is going upwards and when it is going downwards. We look at what happens in these conditions.
This occurs when during an upward trend, prices sharply reverse to the middle band and in some situations to lower band. When this occurs:
If the above conditions are met, we can hope for continuation of the upward trend. Remember that it is still safer to wait for 2 or 3 more candles to confirm that this movement is just a correction and the trade is still going upward. You can then put a buy order.
This occurs when during a downward trend, prices sharply reverse to the middle band and in some situations to upper band. When this occurs:
If the above conditions are met, we can hope for continuation of the downward trend. Remember that it is still safer to wait for 2 or 3 more candles to make sure that this movement is just a correction and the trade is still going downward. You can then put a sell order.
John Bollinger, the man who is credited for the development of Bollinger bands recommends that the bands serve as a guide rather than for an absolute buy or sell signal when price touche the bands. Bollinger bands should also be used together with other trading tools like Fibonacci levels, RSI, Parabolic SAR, ADX, and Stochastic.
This is another tool that works like Bollinger bands. SAR stands for Stop and Reverse. It is one of the most popular technical indicators for trades. When using this tool, a trader can put a buy order when the dots of Parabolic SAR are below the price line, and also put a sell order when the dots are above the price line. This indicator works well when there is a trend in the market, but seems to be of no use when the market is ranging. Parabolic SAR can be combined with Bollinger bands to confirm the price trends before taking a position.
Bollinger bands are an excellent tool for technical analysis. They are very helpful in spotting buy and sell signals. However, they are seldom used alone. They work best when they are combined with other technical tools for maximum efficiency. Using Bollinger bands with price action and candlestick charts seems to be very effective. Bollinger bands can be used on any financial markets, which include stocks, commodities, Forex, futures, options, and bonds. This is why Bollinger bands are considered one of the most popular technical analysis indicators. In addition to using the standard indicators that are available in your trading platform, you might consider complementing Bollinger bands with custom MetaTrader indicators/Robots, tweaking BB in accordance to your own needs.
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