Introduction – What’s Bollinger Bands?
The Bollinger band indicator was created by John Bollinger (an American financial analyst and a really important contributor on the technical analysis field). They are classified as trend indicators because their orientation on the charts can provide information on whether an asset is range-bound or trending. They give an indication of the trading range of the asset without providing information on the strength of any such moves.
Components of the Bollinger Bands
Three bands make up the Bollinger band indicator. These three bands are formed as follows:
- The Upper band, set to 2 standard deviations from the middle band to the upside. In other words, the upper band = middle band + (2 * 20 period standard deviation).
- The middle band is the 20-period simple moving average of price.
- The Lower band, set to 2 standard deviations from the middle band downwards, can also be defined as the middle band – (2 * 20 period standard deviation).
The distance between each of the Bollinger bands gives an indication of market volatility. High volatility leads to wide spacing between the bands while low volume/low volatility trading leads to a narrowing of the bands in a phenomenon known as the Bollinger Squeeze.
In setting up the indicator for use on the charts, the trader must first attach the indicator to the charts and adjust any parameters as required. To attach the Bollinger bands to the chart on the AG Markets MT4 platform, click on the “Insert” tab, followed by the “Indicators” tab on the drop-down menu. Then select “Trend”, and finally “Bollinger Bands”.
A pop-up window will usually open, prompting any modifications to the indicator settings to be carried out. Usually any changes would be to the colour of the bands. However, if the trader wants to use extended upper and lower band settings, the standard deviation of the upper and lower bands can be adjusted.
Trading with the Bollinger Bands
The Bollinger band indicator can be used in two main ways:
- The Bollinger squeeze can be used to trade a breakout situation.
- In a range-bound market, the upper and lower Bollinger bands can be used to trade price reversals.
We now demonstrate the methods by which the Bollinger bands can be used.
- Breakout trading
There are occasions when the trading volumes are very low and volatility is low. At these times, the Bollinger bands narrow greatly to form the Bollinger squeeze. When volatility picks up, the Bollinger bands widen and the price action breaks out either upwards or downwards. The key here is to know when the Bollinger bands will start to widen. In doing this, there is a custom indicator known as the Keltner band indicator which is used in conjunction with the Bollinger bands. Both indicators are added to the charts. The strategy is to detect when the Bollinger bands move inside the Keltner bands (the Bollinger squeeze) and when the Bollinger bands start to move out of the Keltner bands. The Keltner bands are a custom indicator and is available for free on the internet using the search engines.
- Reversal trading
For the reversal trade, the trader aims to sell at the upper Bollinger band or to buy at the lower Bollinger band. This is because when the market is range-bound (which is when this strategy is used), the limits of price action can be determined. Trade confirmation must be obtained from an indicator which shows overbought and oversold market conditions. The strategy works best during times when the majority of the market is waiting for some big news. At these times, trade volumes are low as most traders sit on the sidelines. The advantage is that the trader using this strategy also knows when to abandon this strategy, which is when the major news is released.
Another way to deploy the Bollinger band is when the trader is looking to use the upper and lower bands as confirmation of trade reversal when a candlestick reversal pattern appears on the charts. For instance, if an engulfing pattern were to appear on the charts at either the lower or upper Bollinger band, then this may be a sign to trade a reversal of price which is expected to occur.