In this guide, we have ensured that Bollinger bands explained both visually and simply in the most usable way.
Bollinger bands are one of the more popular technical indicators used by forex and technical traders. Created by John Bollinger, Bollinger bands are used to measure volatility in a financial instrument and visually creates a momentum channel.
They can be used to identify overbought and oversold conditions, as well as to generate trading signals. In this article, we have explained how Bollinger bands work, along with some tips on how you can use them in your trading strategies to improve results!
Bollinger Bands Explained
Bollinger bands are comprised of an upper and lower band, which are placed two standard deviations away from a simple moving average.
The main idea behind Bollinger bands is that prices tend to stay within the upper and lower bands during periods of low volatility, and they break out of the bands during periods of high volatility. When prices breakout of the upper band, this is typically seen as a sign that prices are overextended and may be due for a correction.
Conversely, when prices breakout of the lower band, this is seen as a sign that prices are undervalued and may be due for a rally.
Both of these types of Bollinger bands breakouts are used as types of trading signals that can be confirmed with other technical indicators.
Bollinger Bands Calculation
The calculation for the Bollinger bands is explained as follows:
Upper Bollinger Band = Simple Moving Average + (Standard Deviation x Number of Periods)
Lower Bollinger Band = Simple Moving Average – (Standard Deviation x Number of Periods)
Standard Deviation
The standard deviation is a measure of how far the price of a security has moved away from its mean over a given period of time.
Number Of Periods
The number of periods used in the calculation can be adjusted to suit your trading timeframe. For example, if you are using a daily chart, you may want to use 20 periods, while if you are using a weekly chart, you may want to use 50 periods.
Bollinger Bands Trading Strategy Examples
Now that we know how Bollinger bands are calculated, let’s take a look at some tips on how you can use them in your trading!
Bollinger Bands Trading Strategy 1 – Trend Following
One trading strategy to use Bollinger bands is to wait for prices to breakout of the upper or lower band, and then enter a trade in the direction of the breakout. This is in effect a trend following Bollinger bands trading strategy.
Bollinger Bands Trading Strategy 2 – Possible Reversals
Another way to use Bollinger bands is to look for price action patterns such as candlestick reversals at the upper or lower band. This is then used to pick a reversal point for a change of direction. It could be said that this particular method of trading strategy for Bollinger bands incurs more risk, but if correct in your assertion, the reward can also be quite healthy.
As you can see from this chart above, just after the second set of arrows the price action moves to the outer edges of the Bollinger bands before showing a hammer candle and a reversal in short term trend. If you combined this, with a confirmation upon price moving above the simple moving average, there is a nice (but short) upside swing.
Using Bolling Bands As Confirmation Of Other Indicators – Strategy 3
Whilst not necessarily a Bollinger Bands trading strategy in and of itself, you can gain a lot of value in using Bollinger bands to confirm other technical indicators. For example, if you see a bearish crossover in your moving averages, you can look for prices to start trading below the lower band as confirmation. This multi indicator confirmation is a more reliable way to trade using technical analysis than relying on just a single option.
At the very start of the above chart example, as the price action dips below the moving average and the bands widen to signify volatility, there is a rather strong downside move. This is one representation of using both the trend following strategy, and the confirmation strategy together.
The Best Settings For Bollinger Bands
The most important thing to remember when using Bollinger bands is that they are a single trading tool to help you make better trading decisions, but they are not perfect. Like all technical indicators, Bollinger bands will produce false signals from time to time. As a result, it is important to use them in conjunction with other technical indicators and tools, such as price action analysis.
If you are just getting started with Bollinger bands, we recommend that you start by using the default settings (20 periods). From there, you can experiment with different settings to see what works best for your trading style and timeframe.
If you are ready to put some of your Bollinger bands trading ideas into practice, test on a demo account first with a trading platform that delivers a good range of technical indicators directly on the platform. Once you have achieved successes in a test environment, you can then consider how to recreate that in a live trading environment!