Published: 29 July 2020 by Andrew
Bollinger Bands are the secret to many traders’ success, why? Trading on financial markets is a complex activity to manage. Markets are subject to strong fluctuations, caused by uncontrolled forces and this makes them highly unpredictable.
Market analysis is the only activity capable of curbing unpredictability and bringing order to trading. The technical indicators play a clear role in this, because they are tool through which asset price charts become understandable and legible.
Bollinger Bands are one of the best indicators around. Thanks to the numerous data and clarifications they offer on price trends, they allowed generations of traders to establish themselves and obtain great performances in market operations.
In this guide to Bollinger Bands we will find out how the indicator works. We will explain how it was created and where it came from, but above all we are going to show all its possible uses to have a correct interpretation of the market.
With Bollinger Bands you can greatly improve your performance on the market. Any trading asset can be analyzed and understood thanks to this effective and simple to use indicator,
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Bollinger Bands, where do they come from?
This indicator has a rather bizarre name, we know that, we investigated why it has this name and how it works. For decades, “bands” have been considered one of the best indicators for trading, one of those that work best in all technical analysis.
The name of the “bands” derives from their creator “John Bollinger”. This man is one of the most importanti US financial analysts, he created the bands inspired by a theory of John Hurst. In 2002 he also published a book called “Bollinger on Bollinger Bands”, where he illustrates all his theory in detail.
His activity started around 1980. At that time John becomes an independent financial operator and also joins the Financial News Network. In that editorial, he will become chief financial analyst and will be for a period of 7 years.
Already in the 80s, his theory about “bands” was born and soon it began to spread to other financial analysts. Over the years, his theories have been so successful that he has also won the Lifetime Award for Outstanding Achievement in Technical Analysis. The award is given to those who have made a great contribution to technical analysis and its progress.
Now Bollinger is the chief of his company called Bollinger Capital Management. Here he is the President and manages money by investing it based on technical analysis on behalf of his customers.
Bollinger Bands and Volatility concept
In general, it is possible to understand the Bollinger Bands among the market volatility indicators, but in reality they also have many other functions such as:
- Oscillator range indicator
- Trend indicator
- Accumulation and Distribution indicator
- Over-bought or Over-sold indicator
In short, it can be said that there is no more multifaceted and varied indicator than Bollinger Bands. Its functions are so many that the most experienced traders often choose to use it alone, without the aid of any other technical indicator.
Thanks to their characteristics, Bollinger Bands are used to understand how Forex currencies, or any other financial asset, will move. They anticipate trend reversals and are also able to show the current trend.
If exploited in the right way, they are able to send clear operational signals to the trader. In this way, you can know the ideal moments of entry and exit from the ideal market and use them to your advantage. But most of all, bands help to understand market volatility. Why is this concept important and what does it mean?
Volatility is the measure of the intensity of changes of a security or any market asset (indexes, currencies, cryptocurrencies) in a given period of time. In other words, volatility indicates the percentage change of the value of a security or portfolio: it is a measure of the intensity of the oscillation of its value.
Higher volatility will correspond to more market price changes, while lower volatility corresponds to a more docile price trend. Bands are therefore used to recognize the degree of volatility currently in force on a certain market. This is a fundamental step to understand how to invest and investment risks.
How Bollinger Bands work
The use of bands is based on the theory that within the price of a financial instrument there are so-called “trading envelopes” or simply “envelope”, these are calculated on a percentage that varies between 3 and 4%. Just these envelopes are protagonists in the trading strategies related to the Bollinger bands.
The basis of the Bollinger Bands is another trading indicator, called “simple moving average”. This indicator is so basic that it is used as a data for many other analysis tools. But, from a graphic point of view, what can be observed if you choose to display the Bollinger bands on your trading platform?
Here is an image of what can be seen on the price chart:
The Bands are the 3 sinuous lines or curves that move around the price graph. The latter is represented here by the Japanese candles (which are those vertical red and green segments) which show the upward or downward market trend.
At the center of the image you can see the presence of a red line, that is precisely the Moving Average we were talking about and it is a 20 period average. The other two lines or bands are calculated based on the simple moving average placed centrally.
Read also: Moving Average
Bollinger Bands calculation
In order to display the bands on a graph, the algorithms of the trading platform perform calculations. So the trader does not have to do the calculations himself, but finds the bands ready to be used, based on standard calculation data. In most situations, the standard calculation is fine for investing.
We advise only the more experienced to modify and vary the calculations based on market conditions, while for novice users it is much better to do analysis with the Bollinger bands as they are displayed on the platform. Even so the bands are perfectly capable of generating valid trading signals.
In any case, we report here the calculations that are carried out to obtain the external bands:
- Median band: this is the 20-period simple moving average
- Upper band: median band + 2 * standard deviation at 20 periods
- Lower band: instead it is calculated with the values of the median band – 2* standard deviation at 20 periods.
In principle, Bollinger bands on a graphic level almost always manage to contain the price graph. There are rare cases where the price manages to move outside the bands. We can anticipate that, if it happens that the price comes out of the “fence” created by the bands, making trading operations of any kind is highly discouraged.
Bollinger Bands strategy
Up to now we talked about the Bollinger bands as an indicator of volatility, but now we specify the concept better and explain how the bands should be read to identify an increase or a contraction of volatility.
In addition to this, we also make an introduction of how bands are used to identify other signals from the market and other conditions that occur on the price trend. Reading the Bollinger bands well is essential to learn how to catch valid Buy or Sell signals on the markets.
1 – Read the volatility degree
When a market is very lively and highly participated, there is a high price volatility. Strong price volatility is ideal for market players wishing to have the highest possible profits. However, care must be taken, because volatility is often associated with risks as well.
Whether you want to invest in Forex or the stock market, high volatility brings with it a greater number of trading opportunities. but, how can you understand, through bands, the volatility rate of a market?
There are 2 situations to match out for:
- Volatility increase: in the moments in which, on the graph, you can observe that the Bollinger bands move away from each other in a decisive way, it means that there is an expansion of market volatility. The expansion of volatility means that the price is moving in a specific direction, or a new market trend is about to breakout. In short, it is essential to observe the divergences of the bands to obtain operational signals.
- Volatility decrease: when, instead, on the graph the Bollinger bands that converge and shrink towards the center are observed, there is a contraction of volatility. In this case, similar movements indicate a market in which investors have disinterested and are abandoning their positions. This is how a convergence of the bands occurs, it shows a possible sideway phase of the market.
2 – Read Overbought and Oversold stages
Up to now, we talked about volatility, but Bollinger bands go far beyond the data on market participation and also say a lot about the overbought and oversold phases of a good market title.
These market phases are normally highlighted by momentum indicators or, more generally, by oscillators such as RSI. Precisely for this reason, bands are often used together with RSI or other oscillator for market analysis.
However, Bollinger studied his indicator to become able to provide data also in this sense. This is how bands, once again, prove to be a multifunctional tool.
The two phases are really useful to identify because they speak a lot about the market condition and offer trading signals to be taken into consideration. Let’s find out what the hyper-bought and hyper-sold consist of.
- Overbought phase: in technical analysis, overbought is defined as a condition reached by an indicator when there is an excessive upward movement in prices. The important thing is to note how it reaches this stage, like if it reached its maximum in a bullish sense. Therefore, an equally disproportioned downward movement in the price can be expected. In such conditions, as long horizontal consolidation phase, also called sideway phase, can occur. So, a simple distinction must be made:
for hyper-bought, we don’t refer to an excessive volume of purchases on the market, but rather to an unfounded growth in prices. This means that prices have risen too much and in too little time, such a trend is not sustainable by the market.
- Oversold phase: in technical analysis, a condition exactly opposite, to that described above, is defined oversold. This phase occurs when there is an excessive downward movement in prices. The trader, therefore, at this point can expect an equally disproportionate upward reaction, or a phase of horizontal consolidation of the price. With an oversold phase, we are not referring to a too high sales volume, but simply to a too strong bearish price trend and for this to be considered unfounded and not destined to remain long over time.
In the image below, it is easy to see how the bands offer indications as to the overbought and oversold phases. When they deviate significantly from the price trend, they show market excesses, excellent situations in which to invest.
3 – Read the trends
There is also a third fundamental data that can be obtained from the observation of Bollinger bands, that is, the main trend of the market.
A trend is defined, in technical terms, as the prolonged increase or decrease in the market price. Trends can be of 2 types in terms of time factor:
- Short term: when they last very little and then undergo an arrest that can be identified with a sideway phase, or even a reversal, we talk about short-term trends. These are not very convenient for trading, because they generate few profits.
- Long term: trends can also last a long time and therefore long term trends are defined. This is the most appreciated trend of the investors.
But, how can you quickly spot a trend on the market by looking at Bollinger bands? Here’s how to do it:
- Bullish trend: you can identify a bullish trend, taking place in your reference market, when the price remains within a corridor formed by the moving average and the upper band of the Bollinger bands.
- Bearish trend: on the contrary, you can be sure of finding yourself in a downward trend, when the price remains for a long time between the moving average and the lower Bollinger band.
As you already know, the prices on the markets can also move sideways. This means that no precise directionality is imposed on the marked and the price continues to be negotiated around the same share.
In such cases, it is clear that we are in a phase of indecision. These moments are usually also accompanied by phenomena of contraction of volatility and trading volumes. The moments like these are the most interesting ones for traders. Volatility could explode at any moment and, at that point, all you need to do is identify the new trend and enter the market.
In the image above, you can appreciate the phenomenon described in the previous paragraph. The price, previously blocked in a sideway phase, explodes in a strong upward trend. The red rectangle encloses the sideway phase and the price breakout moment. It is evident that something has inducted buyers to act and run to the markets en masse.
When the market is in a sideway phase, the best strategy to adopt is the wait-and-see one, the best thing to do is to wait for the situation to evolve. The price in these phases tends to move in the vicinity of its moving average, often exceeding it upwards or downwards. However, these are not trading signals to be exploited. It could potentially be false signals.
A beginner must be especially careful because managing the side steps to invest is really very difficult. To have more opportunities to score good scores, the advice is to wait for the moment when the price will come out of this stall phase, generating more reliable trading signals.
Read also: Panic Selling
Bollinger Bands: trading signals
Now, it’s time to talk about the trading signals offered by the Bollinger bands. These are generated by the relationship of the external bands with the price. When the market is trending, it is very likely to happen.
The moment the bands hit the price, this is a clear sign of market reversal. We must therefore be ready to understand if the score received is bullish or bearish.
Here’s how to operate:
- Short trading signal: when the price reaches the upper band and exceeds it from the bottom to the top, the market can be considered overbought. This means that a reversal of the trend may occur in the short term, with a recovery of the bear market. This is the case for opening a sales position.
- Long trading signal: when the price runs very close to the lower band and oversteps it, you may have a bullish reversal signal. In that case, the market can be considered oversold. If the price is too low, it means that the market will seek new levels of equilibrium by becoming bullish.
Read also: MACD
Bollinger Bands: Conclusions
With technical indicators, trading becomes much easier and safer. Thanks to Bollinger bands, you can easily recognize more advantageous trading opportunities and avoid the false signals coming from the market.
In addition to recommending the use of an indicator, we also remember the importance of money management to protect your investments. It is essential to set the Stop Loss to a safe quota that does not exceed 5% of the capital at your disposal.
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They represent a well-known indicator of technical analysis, aimed at making correct forecasts on the markets, which takes its name from its creator.
They have the utility of measuring the volatility of an Asset, in order to determine the future trend of its price.
Certainly all those with the Metatrader 4, such as ForexTB.
Analysts unanimously consider this indicator as one of the best out there because of the accuracy of its forecasts.