What you need to know about Bollinger Bands

Good day, ladies and gentlemen, Forex traders! We continue in-depth study of indicators that have become classics. Those indicators that have brought millions to traders and thousands of traders are still using them today all over the world. Today we will talk about a Bollinger Bands indicator (hereinafter BB), or standard deviation Bollinger range (also known as Bollinger Stripes). We will find out what it shows, strategies of using it in trading and … something more interesting 🙂

Introduction

This indicator was first described by Perry Kaufman in 1987 in his book “The New Commodity Trading Systems and Methods “. Later on, the indicator became widespread, thanks to US technical analyst from California, and the founder of this wonderful indicator, John Bollinger.

John Bollinger was born in Montpellier, France. Later, his family decided to move to New York. John from his childhood was interested in cinema and photography, so he entered the School of Visual Arts in New York, where he received the profession of light operator. By the way, he improved really fast in the operator profession, so he expectedly moved to West Hollywood in 1976. But the meaning of his life and his interests have turned the other way from the time when his mother asked to see her investment portfolio. He completely forgot about the profession of an operator, though it helped him to get to “Financial News” TV channel as an operator, where he was able to personally observe the work of financial analysts and absorb important information. After passing on analytics courses and obtaining the necessary knowledge, he finds a sales analyst job at the TV station. His career on the TV channel did not last long, in 1991 CNBC bought the rights to the television channel, although once a week they still had analytical news by John Bollinger. It was in the period from 1984 to 1991, when he developed his own system of rational and efficient analysis, later called “Bollinger Bands”.

This analysis tool has not lost its relevance today. His book “Bollinger on Bollinger Bands” is a detailed guide to using this tool, both individually and in conjunction with other indicators. And in 1996, he was recognized as the best software developer for financial analysis.

Description of the indicator

Graphically, Bollinger Bands consists of two lines, limiting the dynamics of prices above and below, respectively. It is a kind of support and resistance lines, which are most of the time are remote from the price levels.

Bollinger Bands are similar to moving average envelopes. The difference between them lies in the fact that the boundaries of the envelopes are located above and below the moving average curve at the fixed distance expressed in percents, while the Bollinger Bands borders are based on the distances equal to a certain number of standard deviations. As standard deviation depends on the volatility, the bands are self-adjusting: widening during volatile markets and shrinking during calmer periods.

The basic rule in the construction of Bollinger lines is the following statement - about 5% of the price must be outside of these lines, and 95% inside.

Bollinger bands are formed by three lines. Midline - a usual Moving Average. Top line - is the same as the middle line shifted up to a certain number of standard deviations (eg, two). The bottom line is the middle line shifted down by the same number of standard deviations.

A uniqueness of Bollinger bands is that their width varies in response to changes in market volatility. Bollinger Band is constructed as a band around the middle, but the bandwidth is proportional to the standard deviation from the moving average for the analyzed period. When the market has a large volatility, for example, during a news release, the band expands, when it’s calm in the market – it is shrinking.

As with all other indicators, I recommend analyzing BB along with other indicators. The goal of the BB indicator is to determine the sharp deviations from the average price trend of a currency pair. If BB is chosen correctly, its moving average is a good level of support/resistance, and borders of BB channel may serve signs to open the position. Typically BB bands are plotted on the chart but also can be applied on any indicator drawn in a separate window, such as an oscillator.

Bollinger’s define natural extremes in a developing trend. If the Bollinger aims upwards, the price makes a rebound until some rather powerful force stops the prices progress. Stagnation zone is formed below the upper or above the lower Bollinger. State of stagnation could last as long as Bollinger doesn’t reverse and starts moving away from the price bar that will indicate that the resistance has been broken through. The price can shoot in the direction of the current trend and stick to the Bollinger edge. But do not lose sight of the fact that the final price movement depends on all the support/resistance levels and not just those that are associated with BB.

Do not try to find the ideal conditions for opening/closing positions. Learn to work in imperfect conditions, when you get false signals.

BB indicator calculation

Bollinger bands are formed by three lines. Midline - a usual Moving Average. In the following terms «n» is the number of time segments constituting a period of a moving average calculation (eg. 20 days).

Top line - is the same as the middle line shifted upon a certain number of standard deviations (eg, two). In the following formula «D» represents the number of standard deviations.

Bottom line - is middle line shifted down by the same number of standard deviations (ie, «D»).

J. Bollinger recommends using a 20-period for Simple Moving Average as the middle line, and 2 standard deviations to calculate the bandwidth limits. He also found that moving averages of less than 10 periods are ineffective. Let us display more settings.

Indicator settings

Period

For Bollinger Bands it is recommended to set a period of 13 to 24, the most common - 20, and the deviation at the level of 2 to 5, the recommended value is 2 or 3. You can also use the Fibonacci numbers, a round of 50, 100, 150, 200, the number of trading days and calendar year - 240, 365. it should be understood that the establishment of long periods reduces the sensitivity of the indicator, which is unacceptable in the low volatility markets. Most of the time the price is in the channel, but at a rapid movement, Bollinger Bands crossing is normal. However, if the price crosses the upper or lower band too often, it is necessary to increase the period, and if the price rarely comes to the edges, you should reduce the period.

Price

Most commonly used for calculating the Bollinger Bands are closing prices. other varieties can also be used, such as typical and weighted prices.

Timeframe

Bollinger bands work equally well on all timeframes, but as a rule, they are used for intraday trading.

It is worth remembering that different currency pairs and different timeframes it is necessary to select indicator settings separately.

How to use

The founder himself notes the following characteristics of Bollinger Bands:

• Sudden price changes usually occur after the band shrinks, as volatility lessens.
• When prices move outside of the bands, it means a continuation of the current trend.
• If the pikes and hollows outside the band are followed by pikes and hollows inside the band, the trend reversal is possible.
• Price movement started from one of the band’s lines usually, reaches the opposite one. The last observation is useful for forecasting price directions.

So what are the options for using the BB indicator that I can recommend?

Prices movement outside of the indicator’s borders

Typically, it means the beginning or continuation of the trend. Thus it is possible to judge the direction of the market - until prices touch and break the upper limit, the trend is up. As long as prices break through the lower boundary - downward.

Sometimes going beyond the Bollinger line means “false breakthrough”: when the price only tried a new level, and immediately went back. In this case, there is also an opportunity to work against the trend, but assess exactly – is this “breakthrough” “false”. However, be aware that the transaction against the trend is a game of professionals. And if you think you’re not one of them yet, it might be better to refuse.

The picture above indicates such opportunities. Note that such counter trend opportunities arise infrequently and are generally characterized if it crossed the Bollinger border and is far from the line. Such situations are usually very visible.

Price bounce from the middle BB line and its intersection

As I said, the correct selection of indicator period turns middle BB line into a dynamic support/resistance level, which works great as a confirmation of a trend. Crossing the center line of the indicator often means a change of trend. In point 1 on the picture above trend, intersection took place, at 2 change of trend was confirmed (price touched the upper border of the indicator). At point 3 price again touched the upper limit until in the point 4 it touched the middle line. Upon confirmation of the point by candle formations, by other indicators or graphical analysis (levels, trend), it gives us a reliable entry point in the direction of the new trend.

Note that after the trend change in point 1 of the picture above, the price still came back to the center BB line and bounced back multiple times. However, at points 2 and 3 there were also approaches to the midline. At the same time it was broken through, but the change of the trend has not occurred, it was the false breakdowns. That is why it is recommended when making trading decisions not to rely on a single indicator, and filter all incoming signals using oscillators, candles, graphical analysis. In point 4 again there was median line breakthrough, which led to another interesting phenomenon (point 5), which we will discuss below.

The slope of the Bollinger bands and the location of the price relative to BB

Here everything is simple. The slope of the Bollinger Bands, as well as on the price location with respect to the midline, it is possible to judge the direction of the current trend - the trend is upward at an upward inclination of BB, the trend is downward at a downward inclination of BB. Price location under the middle line indicates a downtrend, while prices above the middle line we can mean an uptrend.

The narrowing and expansion of the Bollinger Bands

As you know, the market tends to move constantly from trend phase to stagnation phase. And when we see that the market is calm for quite a long time – it is worth waiting for the storm. Bollinger band becomes wider when market volatility increases and narrower when it decreases. A narrow Bollinger band indicates a sleepy, quiet market.

The strongest market movements usually start from a flat base (so-called “shelf”). Bollinger band helps to identify the moment of transition from quiet to active markets. When prices rise from a very narrow Bollinger band, it gives a buy signal. When prices fall from a very narrow Bollinger band, it gives a sell signal. If prices come back to the range - you need to close the position. The divergence in BB is observed when the current trend strengthens or a new one begins. The longer the course is traded in a narrow range of the price channel, the stronger and faster will get out of it. In response to the price awakening, BB bands open up. If when approaching the BB border, it starts to grow, the movement is likely to continue.

Watching with a practiced eye on the bands in real time, you can catch the beginning of a new trend. Especially good Bollinger bands operate in the second test of significant levels (highs or lows) by the price. When the market finally makes the breakthrough, expanding price bars reach the borders of Bollinger Bands, and then the bands narrow around narrowing price bars in a sideway range, and after that a breakthrough or rebound from the level occurs.

The continuation and trend reversal

Strong buys and sales can bring the price outside the Bollinger bands. Experience shows that in most cases not more than four candles in a row can be out of the Bollinger line, after which there is a correction or reversal. However, trading against these movements is very risky, as the market may have a short series of very volatile fluctuations before the reverse, and beat out your stops. But, generally, such prices may occur very rarely, usually during London session, on the news.

As mentioned earlier, the indicator depends on the volatility of the market. If the channel borders diverge, it indicates the continuation of the current trend, and if external Bollinger bands are narrowing, this may indicate a trend damping and possible reversal. Breakthrough of the central BB band enhances directional momentum. If when a price is approaching the BB border, the tilt angle of the border decreases, then most likely, the price will break through the border, and then reverse. Very often, this means the end of the current trend. Keep an eye, whether the price bounces back slowly, and the Bollinger opens up. If so, this will be the signal for the upcoming break through the BB boundaries and movement continuation.

Patterns recognition with Bollinger Bands

For example, consider a model of “double bottom”, which means decreasing to low, followed by recovery and a subsequent decrease in the area of the previous low, then there is a reversal, which is accompanied by an increase or at least the end of the previous trend.

The relationship between these two lows for some time was the subject of much discussion among technical analysts. The first low has to be above the second or lows should be equal or the first should be higher than the second one? and so on … I think that the process of identification of these models becomes much simpler and the models themselves become more apparent when you consider the lows relative to the Bollinger Bands and ignore questions of absolute price values.

If the first minimum is below the lower band, and the second one is above or at least on the lower band, we have the potentially interesting situation - divergence, wherein the second minimum is relatively higher than the first, regardless of their absolute price levels. Add to this confirmation and corresponding discipline - and you will get a valuable tool for trading.

The use of Bollinger Bands with other indicators

Generally, BB’s are used in trending systems, where the entry is performed in the direction of the trend after a retracement. In addition to relying on the middle BB line to confirm the end of the rebound, it is logical to use an oscillator.

Well suited for this task is Stochastic oscillator or WPR

A very interesting field for experiments - the use of the Bollinger Bands indicator on oscillators.

At the same time such a bunch as a rule greatly expands the possibilities of standard oscillators - in particular, it adds dynamic overbought/oversold levels, which can be easily adapted to changing market conditions. In particular, you can build your analysis on BB applied to the price chart and RSI oscillator chart.

 

Many of the signals first come from RSI-BB bundle and only later are confirmed by a bundle BB-price. The proposed method of using BB bands is a huge field for experimentation.

Advantages and disadvantages of BB bands

The attractiveness of the Bollinger Bands for traders lays in two very important characteristics. Firstly, the Bollinger Bands (BB) show the main axis of the trends/sideway ranges, just as the price or moving averages do. Secondly, while moving they are narrowed, then expanded. And the interaction of these properties of Bollinger bands determines unique models when price bars pass through certain borders. Candles work especially well with Bollinger bands. For example, “Doji”, colliding with narrowing bands provide an effective signal to a short-term price reversal.

Bollinger Bands (BB) react to price movement with its twists and turns. These movements anticipate how far the trend may spread before market powers return it to its central axis. Between the price/bands direction and the narrowing of price/band, there is a complex set of interactions. It requires a very wide practical experience to determine the final impact on the price of these bands. But, after spending many tens or even hundreds of hours watching this indicator, you will not regret the effort. Bollinger bands indicate the hidden nature of price fluctuations much better than many other tools do, and immediately let you know whether opened or closed the cherished door is, behind which the profits are hidden.

The drawback in the indicator is the same as that of the standard moving average - delay. And the higher the period of BB, the more essential it is. However, many traders in their trading use the BB, learning how to neutralize its weaknesses and maximize strengths.

By the way, if you decide to use BB in your forex trading, such an oscillator as CCI can be safely thrown away from the chart. It is based on the same principles as the bands and measures the deviation from the MA. Ranges are better because they leave you visually closer to prices.

Conclusion

If you are using moving averages in your trading, then you just need to consider the option of the trading system with the use of such a multi-indicator as Bollinger. If you have not seen anything with moving averages, nor with the BB, I recommend you try out options by its use as set out in this article - they are at least worth considering.

Take care, Michael

ForexTraderPortal.com