Bollinger Bands: Definition and how to Use

Bollinger Bands are tools used in technical analysis. Bollinger Bands tend to appear with the copyright symbol due to the fact that they were developed and copyrighted by technical trader John Bollinger. Bollinger bands are composed of three lines that are plotted on a chart, including the moving average, an upper band, and a lower band. When the price consistently touches the upper Bollinger Band, it can signal an overbought signal. If the price consistently touches the lower band, it can indicate an oversold signal.

Understanding Bollinger Bands

Bollinger Bands® are made up of a centerline and two price channels or bands, above and below it. The centerline is usually a simple moving average, while the price channels represent the standard deviations of the stock being analysed. The bands expand and contract in response to the volatility of the stock’s price movements or when it enters a phase of tight trading pattern (contraction).

A stock may trade in trends for long periods, but with some volatility from time to time. Traders use the moving average to filter the price action, allowing them to better see the trend. This way, they can find out how the market is moving. For instance, the market may consolidate after a sharp rise or fall in the trend, trading narrowly and crisscrossing above and below the moving average. To better monitor this pattern, traders use the price channels, which include the trading activity around the trend.

Even though markets fluctuate on a daily basis, they are still trading in an uptrend or downtrend. Technicians use moving averages with support and resistance lines to predict the price action of a stock.

Stock prices are considered to be overbought when they continually touch the upper Bollinger Band®. On the other hand, they are considered to be oversold, which triggers a buy signal when they continually touch the lower band.

When using Bollinger Bands®, the upper and lower bands are designated as price targets. If the price rebounds off the lower band and goes past the 20-day average (the middle line), the upper band becomes the upper price target. Prices usually fluctuate between the upper band and the 20-day moving average during a strong uptrend. When this pattern occurs, a cross below the 20-day moving average signals a trend reversal to the downside.

How to calculate Bollinger Bands®

To calculate Bollinger Bands®, the first step is to determine the simple moving average (SMA) of the security, usually with a 20-day SMA. A 20-day SMA averages the closing prices for the first 20 days as the first data point.

The next data point drops the earliest price, the price on day 21 is added, the average is calculated, and so on. Next, the standard deviation of the security price is calculated.

For a given data set, the standard deviation calculates how far numbers are from an average value. standard deviation can be calculated by taking the square root of the variance, which is the average of the squared differences of the mean.

Next, multiply that standard deviation value by two and add and subtract that amount from each point along the SMA. Those produce the upper and lower bands.

What do Bollinger Bands® tell you?

Bollinger Bands® provide traders with an indication of where the market is heading based on prices. As already mentioned, three bands are used in this process: one for the upper level, one for the lower level, and the third one for the moving average. Prices that move closer to the upper band may suggest that the market is overbought. Conversely, a move in prices towards the lower or bottom band suggests that the market may be oversold.

The squeeze

The core concept of Bollinger Bands® is the “squeeze.”. When the bands contract and move closer together, it is called a squeeze. A squeeze indicates a period of low volatility and is often viewed by traders as a potential sign of increased volatility and possible trading opportunities in the future.

However, as the bands move further apart, the possibility of a decrease in volatility increases, increasing the possibility of exiting a trade. These conditions are not trading signals. The bands do not specify when the change may take place or in which direction prices could move.

Breakouts

Approximately 90% of price action occurs between the two bands. Any breakout above or below the bands is important. Many investors mistakenly believe that when the price hits or exceeds one of the bands, it is a signal to buy or sell. However, the breakout is not a trading signal. Breakouts provide no hint as to the direction and extent of future price movement.

Limitations of Bollinger Bands®

One of the main limitations of Bollinger Bands® is that it should not be used as a standalone trading tool. It is just an indicator, providing traders with information about price volatility. John Bollinger suggests using them with other non-correlated indicators that provide more direct market signals and indicators based on different types of data.

Another drawback is that Bollinger Bands® are calculated using a simple moving average, which means older price data is weighted the same as the most recent data.

Which indicators work best with Bollinger Bands®?

Many technical indicators function best when used in conjunction with other ones. Bollinger Bands® are often used with the relative strength indicator (RSI) and the BandWidth indicator, which indicates how wide the bands are in relation to the middle band. Traders use BandWidth to find Bollinger Squeezes.

How are Bollinger Bands used in Forex trading?

Bollinger Bands are a popular tool with technical analysts and traders in all markets, including forex. Given that traders of currencies look for small price movements to profit from, recognising volatility and trend changes quickly is crucial to developing a profitable strategy.

Forex trading is one of the most popular trading markets in the world, with much more activity than the stock market. The idea is to take advantage of the small fluctuations in exchange rates, which allow a trader to generate profits by buying and selling different currencies at suitable prices. Basically, the theory is the same when you trade any asset. If you expect the price of a currency to go up, you will buy the currency. If you expect the price of the currency to go down, you will sell the currency.

In summary

While every strategy has its drawbacks, Bollinger Bands® are considered one of the most useful and commonly used tools for identifying extreme short-term security prices. Bollinger Bands® are a useful tool for traders for assessing the relative level of over- or under-sold position of a stock and providing guidance on when to enter and exit a position. Certain aspects of Bollinger Bands®, such as the squeeze, are effective for currency trading. Buying when stock prices go below the lower Bollinger Band® often helps traders take advantage of oversold conditions and profit as prices move back up toward the centre moving-average line.

Disclaimer:
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked in this communication.