What are Bollinger Bands
Bollinger bands what are they?
Simply… Bollinger Bands are a technical analysis tool based on price to gauge when the market could be overbought and oversold.
The main bands are actually trendlines set by two standard deviations from the moving average, one on the positive side and another on the negative side.
What you’ll learn in this guide:
3 Main components of a bollinger band indicator
Who made the Bollinger bands
How does the Bollinger Bands work
Bollinger Band Calculations
Best settings for Bollinger Bands
There are 3 main components you need to identify when using Bollinger Bands:
The simple moving average which shows the average price over a selected range, this shows a smoothed out price to get a view of the trend.
The top Bollinger band which is the positive standard deviation; the area which shows the underlying price is growing abnormally and could be overbought.
The bottom Bollinger band which is the negative standard deviation, the area showing the underlying price weakening abnormally and could be oversold.
John Bollinger - The Father of Bollinger Bands
John Bollinger trademarked Bollinger Bands stemming from his last name with the goal of trying to find oversold and overbought areas using price alone.
However, the real question to ask is… does price tell a big enough story on being “overbought” and “oversold” or does it need to be in confluence with extra factors such as fundamentals to understand market direction.
There’s no point trying to find overbought short positions if you’re unclear of market direction!
A key way to figure out market direction is firstly understanding the value, just like you figure out if a car is worth buying. You check the specifications, the quality, how far it’s driven and so on. You don’t base that judgement on price alone because you know it could be worth nothing!
The main way to figure out value is by getting a fundamental outlook of the market, this can be done following a Global Macro approach. Feel free to watch a free two hour class on that here.
How does the Bollinger Band work?
The standard deviation for the Bollinger Bands use volatility to figure out where they should be drawn. This standard deviation changes as volatility increases or decreases.
For example, if prices were to increase or decrease abnormally during a big news event then volatility would increase.
When prices increase or decrease dramatically the bands get wider.
When prices increase or decrease at an average volatility over the period then you’ll see the bands narrow.
Interesting behaviours of price within the bands is that they may tend to bounce from the upper and lower bound or the moving average.
Don’t be quick to use them to buy or sell though!
Prices can hug one of the bands for a prolonged period during big trends.
When the trend is grinding to a halt you may see price move back towards the moving average and then the opposite band.
The Bollinger Band is a very dynamic technical analysis tool which makes it a great addition to wider strategies and there’s no fixed way to use it.
One of the main limitations which I’ll get onto later is since the tool is based on historic price and volatility, it’s reactive and not predictive.
Great way to use a Bollinger band strategy would be to combine it with the Global Macro Trading approach.
Bollinger bands calculation
First, calculate a simple moving average.
Next, calculate the standard deviation over the same number of periods as the simple moving average.
For the upper band, add the standard deviation to the moving average. For the lower band, subtract the standard deviation from the moving average.
There are 3 different parts you need to calculate:
First one being the “simple moving average”, generally a 20 day period.
Second, the “upper band” which is calculated by adding the standard deviation of the moving average (add a 2 standard deviation).
Finally, the “lower band” which is calculated by subtracting the standard deviation of the moving average (subtract a 2 standard deviation).
The above 3 images are the different settings over the same timeframe and it shows how the Bollinger bands can change quite frequently.
Bollinger Band Calculations:
There are three different calculations which can change how volatile the Bollinger bands will be. The short term calculation will have more extreme changes as there’s less data for the moving average to work from and as the calculation takes on more periods it becomes more smoothed.
Short term Bollinger Bands Formula:
10 day moving average, bands at 1.5 standard deviations. (1.5 times the standard dev. +/- the SMA)
Medium term Bollinger Bands Formula:
20 day moving average, bands at 2 standard deviations.(2 times the standard dev. +/- the SMA)
Long term Bollinger Bands Formula:
50 day moving average, bands at 2.5 standard deviations. (2.5 times the standard dev. +/- the SMA)
You can see the above 3 settings show different types of Bollinger bands as the settings change drastically.
What is the best setting for Bollinger Bands
The trading time frame will impact which Bollinger band calculation you want to use.
If you’re a short term trader anything from the daily timeframe and day traders then using a short term Bollinger band formula will be useful.
Swing traders who hold trades anywhere between a 1 week or longer a medium term formula will be useful.
Then if you’re a longer term trader where you hold trades longer than 3 months then a long term Bollinger band formula will be most applicable.
Bollinger Bands Indicator
The Bollinger Band indicator is built into many different platforms.
For example, on Trading View you can search for a Bollinger Band indicator and easily set the calculations you want without manually doing it yourself.
Step 1: Setup the indicator
Step 2: Set your parameters
Step 3: Start using the Bollinger bands in your strategy
Are Bollinger Bands Good?
Just like any other technical indicator, most are useful. However, it’s not going to make you day trade to a millionaire or figure out the direction of the markets.
What it is useful for is identifying the volatility spikes and figuring out on price alone if markets are set for a pullback or retrace.
The question of whether it’s good or bad totally depends on the trader.
Some traders may love using Bollinger bands, others maybe not.
The main point you need to remember is that Bollinger bands are reactive to price and therefore lagging in nature but tell a good story of overall volatility in the price.
Bollinger Band Strategy
Now that we know what the Bollinger bands do, how they’re calculated and the goal of using them. We need to use them in an overall strategy. There are different ways to implement the Bollinger band strategy including the Bollinger squeeze, reversal and W/M formations.
What is the Best Bollinger Band Strategy
In the following section we’ll go over the different types of strategy patterns and also the best confluence to use with Bollinger bands.
How do you read a Bollinger band indicator
There are several ways traders can use the Bollinger band indicators in their overall trading strategy whether it be when you’re forex trading or stock trading.
The first way to read the Bollinger band indicator is the Bollinger band squeeze.
Bollinger Band Squeeze
The Bollinger band squeeze is when the bands squeeze or contract together. This is a strong sign that there could be a potential breakout soon.
One way to figure out if there will be a breakout is seeing which side of the band price eventually breaks out from.
If price breaks below the lower band after the bands were close then it could be a sign of a downwards move.
If price breaks on the upper band then it could be a sign that prices are expected to move into the upside soon.
Bollinger Band Breakout
The Bollinger Band Breakout System is similar to the squeeze but like an adoption.
The Bollinger Band Breakout Strategy is when you wait for the price to breakout one of the bands.
After the breakout you wait for the price to come back towards the moving average.
When price closes on or very close to the moving average traders could expect a continuation in the direction price broke out from.
Bollinger Band Bounce
The Bollinger Band Bounce Strategy is exactly what it sounds like…
The main logic around this strategy is waiting for price to bounce off the band's back to the moving average.
Reversal signs on the outer bands would be great signs of this happening.
It’s a really simple way of using Bollinger bands for beginners just getting into using the indicator.
Bollinger Bands W bottoms
The W Bottom Bollinger Band Strategy is normally a bullish signal.
The pattern forms towards the end of downtrends and looks similar to the technical pattern “double bottom”.
One interesting difference between a W bottom and a double bottom is that the second low can be lower than the first one.
However, it should sit above the lower band to signal weakness in sellers.
The final confirmation will then be prices breaking the moving average and resistance.
Bollinger Bands M Tops
If you’re a trader who has researched a bit about technical analysis, you’ve probably heard of the double top.
It kind of looks like two mountain peaks next to each other.
The M Tops Bollinger Band Strategy is a very similar concept.
The main difference is that the highs of the peaks don’t need to be equal, it can be lower or higher.
What you want to do when using this strategy is wait for reactions which create the M shape for the peaks on the upper band.
Ideally waiting for bearish signs near the upper band not reaching it as this can suggest potential weakness in upwards momentum as sellers take control.
Finally, you want to wait for the support to break from the bounce from the middle of the M shape.
Overall, this is a potentially useful bearish timing mechanism for your trades for either getting into trend or catching reversals.
Bollinger Bands Reversals
Finally, one of the great ways Bollinger bands can be used is for reversals.
Reversals Bollinger Band Strategies can be implemented when price tends outside the bands then closes inside after.
Traders when looking for reversals tend to wait for price to close above the band to show an extreme price movement.
Afterwards, they will try to see if the market reacts by waiting for price to close within the bands again, this could suggest a pullback or reversal is about to happen.
Overall, you could see it as a good opportunity to catch a market correction as prices go back to their equilibrium of growth.
Bollinger Bands Forex
Just like trading any other security the Bollinger bands can be used to trade forex too.
Some things to watch out for are using Bollinger bands during highly volatile events or market cycles.
This can cause prices to skyrocket outside of the bands for periods of time which may make some strategies take on more losses than usual.
Additionally, because markets are less volatile in forex than in stocks you may not see the same large moves you might see in stocks when using these strategies.
Wrong Way to use Bollinger Bands
To end the guide there are a few wrong ways that traders get trapped in using the Bollinger bands.
The main trap is they don’t realise Bollinger bands are reactive not predictive.
Traders will try to use the Bollinger bands to enter trades and predict market direction.
However, this is the wrong way about it.
Ideally, you already want to know which direction the market has the highest probability of moving towards.
This can be done using the Global Macro approach or doing the fundamental analysis to see what the value of whatever you’re trading should be.
Once you have directional bias you know what signs and strategies to use.
E.g. if the fundamental analysis is suggesting an upside direction, you can look for a W bottom strategy formation.
You do NOT want to be using Bollinger bands to predict price direction rather use it as potential times to enter your trades.
Looking to learn about forex trading properly?
Global macro trading is a great confluence indicator to use with the Bollinger bands you can get started on a webinar which covers the basic here.
The fundamentals of the markets are really important to consider when trading with Bollinger bands, some of the fundamental indicators we use area a great confluence with Bollinger bands in your overall strategy.