TRADING WITH BOLLINGER BANDS EXPLAINED
Explanation & Definition:
Bollinger Bands use the concept of a simple moving average – which takes the previous X number of prices and smooths them over a defined period of time (e.g. 20 periods/days, 50 periods/days) to see how far the current price is from the average. This moving average is accompanied by two separate lines, typically with two standard deviations plotted above and below it.
The top and bottom lines can be set to a different setting depending on user input, such as 1.5 standard deviations or 3 standard deviations from the mean.
Bollinger bands that use the default configuration of a 20-period simple moving average and bands with two standard deviations from the mean are referred to as the (20, 2) setting. Virtually any trading software will allow you to customize this configuration, including switching from a simple moving average to an exponential moving average.
BOLLINGER BANDS SETTINGS:
- Moving average period (Lenght)
- Standard Deviation
Bollinger bands are commonly used as a “reversion to the mean” indicator. If the price is below the Bollinger bands, this could be taken as an indication that the price is currently too low. If the price is above the Bollinger bands, the price can also be interpreted as being too high. Bollinger bands are also commonly used as a volatility indicator. When the price is volatile, the bands widen; when volatility is low, the bands contract.
INTERPRETATIONS OF THE BOLLINGER BANDS:
- Price below the Bollinger Bands = Price too low
- Price above the Bollinger bands = price too high
- Bollinger bands widen = high volatility
- Bollinger bands contract = Low volatility
Some traders may interpret the indicator in another sense. If the price is trading outside the bands but trending in the general direction of the indicator – which is basically just three separate but parallel moving averages – Bollinger bands can be considered a trend following indicator.
The bands could also be considered as a pure volatility indicator. When the bands contract due to a period of low volatility, commonly referred to as a “squeeze,” it could indicate an impending bout of high volatility. Conversely, if the bands are expanding, this could indicate an upcoming period of low volatility. Those in need of volatility or a trending market could likely close out trades or reduce positions during periods of band expansion.
Example #1 – Trend Reversal Strategy
Here we have a chart of EUR/USD in 1 hour timeframe with Bollinger Bands in setting (20, 2):
Some traders interpret the closing price of a full candle outside the bands as a trading signal that the price is oversold (when it is below the bands) or overbought (when it is above the bands). Therefore, trading opportunities may be skewed in the opposite direction.
Traders using the bands in this sense will be doing the opposite of a trend following system, unless one would follow the trend on a longer charting time frame and the Bollinger Bands on a smaller separate one. For example, if a trader were to consider long trades based only on the trend of the daily chart, but saw an hourly candle close fully below the lower Bollinger band, he might consider buying the asset.
Example #2 – Bollinger Bands with configured settings
If we use the same chart but set it to the (20, 3) setting, this would produce more conservative signals for a possible “reversion to the mean”. Of course, the bands are much wider. A three standard deviation setting would theoretically capture 99.7% of the price data, not just 95% of the price data.
Example #3 – Shortening the moving average
We can also shorten the moving average to 10 periods. If we leave the standard deviation setting for a (10, 2) setting at 2, we get the following:
Since the period is smaller – the moving average takes into account the last 10 periods of price data, instead of going back 20 periods in the case of the default setting – the bands are much more responsive to the current price. This means that the price data is more likely to stay within the bands, as the minute price is more incorporated into the indicator’s formulation.
Example #4 – Not all settings are useful
As a general rule of thumb, the shorter the time period and the higher the standard deviation setting, the more likely it is that the current price will be within the bands. If we extend the time period to 200 and lower the standard deviation to only 1 (i.e. to the setting (200,1) as shown below), the indicator has very little value.
So much previous price data is incorporated into the bands that the current price is only 0.5% of its calculation (compared to 5% at the default 20 period setting), and the standard deviation is so small that much of the data will naturally fall outside the bands.
Interim conclusion on Bollinger bands
Bollinger bands are wide open to interpretation in terms of what they communicate best, and vary in terms of how traders use them:
- In one sense, they represent a “reversion to the mean” intended to show whether price might be overextended in one direction or another.
- In another sense, they could be interpreted as a trend-following indicator, where a price outside the bands indicates a “breakout.”
- Bollinger bands can also present a clear picture of current volatility in the market, with contracted bands indicating low volatility (with the potential for a breakout) and wide bands indicating high volatility (with the potential for a subsequent period of low volatility).
Bollinger bands alone are not designed to be an all-in-one system. How to interpret them on a chart depends very much on the trader.
The indicator’s developer, John Bollinger, recommended using the indicator in conjunction with several other uncorrelated indicators to better interpret trend and volatility, such as the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and On-Balance Volume.
Recommended platforms and brokers for Bollinger Bands trading
The recommended platform for Bollinger Bands trading is MetaTrader 4/5, which is a universal charting platform with many other indicators. You can perfectly adjust the Bollinger Bands to the chart and your strategy. To do this, you need a broker who will provide you with the data and give you access to the market.
Bollinger Bands %B
Bollinger Bands %B translates part of the price information in Bollinger Bands to another line on the chart, rather than multiple bands that you see with the standard indicator.
Percent B is to show where the price is relative to each band.
%B is calculated as: (Price – Lower Band) / (Upper Band – Lower Band)
This can be translated as follows:
- %B > 1: Price above the upper band
- %B = 1: Price equal to the upper bandwidth
- %B between 0.5 and 1: price closer to the upper band than to the lower band
- %B = 0.5: price equal to the middle band
- %B between 0 and 0.5: price closer to the lower band than to the upper band
Below is an hourly chart of the EUR/USD with the default Bollinger Bands setting – 20-period moving average and upper and lower bands with two standard deviations above and below the mean (sometimes shown graphically as the middle band, but not shown in this case).
As can be observed, the Bollinger Bands %B indicator provides the same information as the regular Bollinger Bands indicator in terms of the difference between the price and the upper and lower bands.
However, it does not show information about volatility in terms of the difference between the upper and lower bands. This difference is crucial for some traders to judge whether they are in a trade or not.
A narrow gap between the upper and lower bands may indicate a price breakout in one direction or the other (also commonly referred to as a “squeeze”), while a wide gap between the bands may indicate an upcoming period of relatively low volatility.
Conclusion on Bollinger Bands:
The Bollinger Bands %B indicator quantifies the distance between price and the upper and lower bands, which can help technical analysts determine trends. Some traders also generate trading signals based on whether the %B indicator is above 1 or below 0, which could result in either trend following or price reversal. However, it is not recommended to use the %B indicator (or any other indicator) in isolation.
To get the volatility component – which the Bollinger Bands %B does not capture – one would have to either rely on the standard Bollinger Bands or use the Bollinger Bandwidth. This indicator is an important component of a technical analysis.