Bollinger Bands are overlay indicators we can use to spot significant levels of price reaction in the market. Firstly introduced By John Bollinger, in the book “Bollinger on Bollinger Bands”, they have acquired an increasing importance in the technical trading landscape.
Their usages are multiple: by the end of this short guide, you will understand what they are and foremost how we can use Bollinger bands to improve our every day trading.
- Understand the Bollinger Bands Indicator;
- Everything You Need to Know About Bolling Bands;
- Volatility Increases – Price Walks on One Bands;
- Volatility Decreases – Bollinger Bands Squeeze;
- The John Bollinger’s Complete Set of Indicators;
- The Bollinger Bandwidth;
- The Bollinger % B;
- How to use Bollinger Bands;
- Identification of Potential Support and Resistance Levels;
- Trend Identification;
- Bollinger Bands as an Entry Trigger;
- The Breakout Strategy;
- The Reversal Strategy;
Understand the Bollinger Bands Indicator
Bollinger Bands are technical overlay indicators: they interact with price action. Usually, they are set around a 20-periods simple moving average with an upper and lower band, each one placed at two standard deviations away from the central value.
Graphically, on TradingView they appear like this:
We can notice that Bollinger Bands are a method of price containment. In this case however, in contrast with other traditional bands, they are able to catch market volatility. When bands diverge, volatility increases; rather, when they converge, volatility decrease.
Bollinger Bands Explained: Everything You Need to Know About This Trading Indicator
Bollinger Bands aren’t simple lines. They represent levels of overextension in price action. They help traders to spot overbought and oversold conditions in the market, like the RSI indicator for example.
More specifically, if price is:
- on the Upper Band – We are in an Overbought Condition;
- on the Lower Band – We are in an Oversold Condition.
But that’s not all!
Bollinger Bands works great to spot the level of market volatility.
Strong Volatility – Price Walks on One Bands
During a phase of strong price movement, this last tends to walk on a band, producing a widening in the Bollinger Band:
Low Volatility – Bollinger Bands Squeeze
During phases of low volatility, Bands tend to converge, narrowing the width of the bundle. We talk about Bollinger Bands Squeeze. Look at this example:
As you can notice, when volatility decrease bands converge producing a squeezing condition. This is more evident looking at the behaviour of the Bollinger Bandwidth indicator: let’s see how it works!
The John Bollinger’s Complete Set of Indicators: the Bandwidth and B% Indicators
Even if Bollinger himself advise to use this indicator combined with complementary oscillators like RSI or Stochastic, we can use Bands with other two window indicators both introduced by the same author: I’m talking about the Bollinger Bandwidth and the Percentage B.
The Bollinger Bandwidth indicator
Bollinger Bandwidth indicator, is a simple windows oscillator who tracks the percentage difference between the lower and the upper bands.
It’s reading is easy: when Bandwidth is low, bands are close to each other and we have a Bollinger Bands squeeze condition. Instead, when bandwidth increases, we register an increment in volatility with divergent bands.
The Bollinger Bands % B
Bollinger Bands Percent B works complementary to the previous oscillator. It tracks the position of price relative to the bands.
A value equal to one corresponds to price being on the upper band. Instead, a reading equal to zero corresponds to price being at the lower band.
Percent B makes clear when price touch a Band, but that’s not all.
We should remember that these are zones of overbought or oversold levels, and so levels of overextension in price action.
For this reason, we might expect price to bounce back towards inside after testing these levels: in the picture above, you can see how I used a green line to spot the overbought condition, and a red one for the oversold one.
How to use Bollinger Bands: Additional Usages
I like the versatility of this indicator, as I like the multiple usages of moving averages in technical analysis. Until now, we’ve discuss about two usages off Bollinger Bands:
- Find OBOS conditions (OverBought and OverSold);
- Gauge the average volatility of price action.
But that’ not all: let’s now review the main Bollinger Bands rules we can refer to for a real-life trading.
Identification of Potential Support and Resistance Levels
Both bands and the central value of the Bollinger act as major levels of support and resistance in the market.
But while the central value act just as dynamic market structure, when talking about upper and lower bands we must remember that price tends to re-bounce when approaching them.
The reason behind is simple and it’s the same as seen while talking about percent B: these bands represent OBOS levels in which we might expect a price reversal:
For novice traders in particular, these volatility bands may help to spot the overall market trend.
Whenever bands are flat and start to squeeze, we are in a consolidation phase.
Rather, during trend phases in which volatility increases, bands start to diverge, moving at a higher rate of growth:
Bollinger Bands as an Entry Trigger
There are two common approaches to enter a new trade using these volatility bands: for a breakout, or for a reversal.
The Bollinger Bands Breakout Strategy
The breakout strategy it’s a common approach when talking about volatility bands. Despite this, personally I don’t like this method.
Look at the following example:
We are in forex market, EUR/USD cross on 4h chart. The Bollinger Bands Breakout Strategy requires an entry:
- Short – when price approach lower band;
- Long – when price approach upper band;
The logic behind this strategy is that once price breaks a band, we look for a further continuation in price action: we “bet” on an additional overextension in the market.
Well, even if in some cases we can have an accurate signal, we must remember that bands spot OBOS conditions in the market, in which price experience an overextended condition: it’s likely that this last will retrace towards the inside of the Bollinger Indicator.
In the chart above you can see that in 6 cases out of 8 we have a false signal for enter in the trade: winning rate was equal to 2/8 = 25%, too low.
In addition to this consideration, we must think that the overall return is also influenced by the price filter used to spot true and false market breakouts (like for example a price retest, or a closing price violation).
Even if sometimes this approach works, I think it provides too many false signals in the market. Moreover, the results of this strategy are highly correlated with the price filter you use to spot a true or false breakout, which depends strictly on your trading strategy and style.
Let’s now move forward to the reversal strategy.
The Bollinger Bands Reversal Strategy
We’re now considering a different approach to Bollinger Bands trading, looking for reversal entries in the market. Switching our mindset, we enter in a trade:
- Short – when price approach the upper band;
- Long – when price approach the lower band.
Look at the previous example, but consider this new approach:
In this case, winning percentage is higher, since only in 3 cases we had a false signal which produced a loss.
Well, even in this case much of the profits or losses depends upon which filter used to enter in the market, but also how you decide to manage you position setting-up specific rules for Bollinger Bands trading (position size, stop loss, take profit).
Remember, TRADING IS NOTHING WITHOUT BACKTESTING.
Before to implement whatever strategy in real-time trading, you have to test it back in the past, looking at how it behaves: you will understand how the strategy works, what results you might expect and most of all you will be able to manage the emotional part involved in trading in an improved way.
Even in this case, we can set a price filter to enter in the market or simply we can decide to enter with a limit order when price approach one band.
In this article, we’ve seen what Bollinger Bands are and how we can exploit them to improve our trading.
We’ve discuss about the many usages of this indicator, able to combine some peculiarities of moving averages with other properties of oscillators (RSI and Stochastic for example), like spotting Overbought and Oversold conditions in the market.
We’ve also seen 2 trading strategies and 2 complementary oscillators introduced by John Bollinger himself.
What do you think about this volatility bands? Are you using it in your everyday trading? Or will you implement it later on? Let me know in the comments if you wish.
Good luck for the next trade! I hope to see you again here on tradingclimb.com