John Bollinger created the Bollinger Bands in the 1980s as a technical analysis tool for trading equities. The bands make up a volatility indicator that calculates the price of an asset in proportion to past trades’ relative highs and lows. Standard deviation, which alters with volatility rises or decreases, is used to quantify volatility. When prices rise, the bands get wider, and when prices fall, they get narrower. Bollinger Bands can be used to trade a variety of securities because of their fluid nature.
The upper, middle, and lower bands make constitute a set of three lines known as Bollinger Bands. The trader selects the moving average’s settings for the middle band. On either side of the moving average band are the upper and lower bands. The trader chooses how many standard deviations the volatility indicator should be set at. The distance between the central band and the upper and lower bands is in turn determined by the number of standard deviations. The location of these bands indicates the strength of the trend as well as probable high and low price levels that could be anticipated in the near term.
How to trade using Bollinger Bands
The strength of an asset’s upward trend and any potential reversals or losses in momentum can be seen using Bollinger Bands. A strong enough rise will frequently reach the upper band. The commodity is pushing higher when an uptrend approaches the top band, and traders can take advantage of the situation to decide to buy.
Price retracements within uptrends, as long as they remain above the center band and the price advances back to the top band, are very strong signs. In general, a price in an uptrend shouldn’t touch the bottom band; if it does, this could indicate that the trend is about to turn or that the commodity is waning.
Prior to a reversal, the majority of technical traders aim to make money from the strong uptrends. To prevent losing money from a trend reversal, traders frequently sell a stock once it fails to hit a new top. Technical traders keep an eye on an uptrend’s behavior to see whether it exhibits power or weakness, and they use this as a sign of a potential trend reversal.
Disadvantage of using Bollinger Bands
Bollinger Bands can be used to gauge how quickly an asset is declining and when it might be about to turn upward. Price will typically follow the lower band during a persistent slump, which indicates that selling pressure is still intense. However, if the price does not reach or veers away from the lower band, it may indicate that the downtrend is losing steam.
Price pullbacks (highs) are a sign of a very strong decline when the price remains below the middle band before moving back to the lower band. Prices in a downtrend should avoid breaking above the top band because this would suggest that the trend may be changing or slowing.
Except than seeking for a chance to buy when the trend starts to change, many traders steer clear of trading during downtrends. The downtrend may last for little periods of time—minutes, hours, weeks, days, months, or even years—or for very long periods of time. Investors must spot downturn warning signs early enough to safeguard their investments. Traders must exercise caution to avoid engaging in lengthy trades that will turn out to be unsuccessful if the lower bands demonstrate a consistent downtrend.
M tops and W bottoms
Bollinger Bands can be employed in pattern recognition to establish or clarify pure price patterns like “M” tops and “W” bottoms, momentum shifts, etc., according to John.
This formation’s first bottom typically has high volume and a fast price decline that closes outside the lower Bollinger Band. Typically, actions of this nature trigger a “automatic rally.” In the base building process that takes place before the stock climbs higher, the peak of the automatic rally frequently serves as the initial level of resistance.
The price makes an attempt to retest the most recent lows once the recovery starts in order to assess the strength of the purchasing pressure that entered at that bottom.
The retest bar is often searched for by Bollinger Band specialists as it prints inside the lower band. This suggests that the negative pressure on the stock has abated and that buyers are now outnumbering sellers. Pay special attention to the volume as well; you need to notice a sharp decline in it.
Trend reversal
Fading stocks when they start printing outside of the bands is another easy-to-use but successful trading strategy. We’ll go a step farther and incorporate some candlestick analysis into this plan.
For instance, wait to observe how a stock performs rather than shorting it as it approaches its upper band limit. A stock that parabolically moves or gaps up and then closes around its bottom while trading outside of the bands is frequently a sign that the stock will soon correct.
If the stock finds support, you can then take a short trade with three target exit points: either the upper band, middle band, or bottom band.
We can see from the same chart as above that the rise off the first bottom resulted in a short-term overbought condition.
Bollinger Bands Squeeze
Profiting from the beginning of an approaching squeeze is another trading strategy.
John invented a gauge called the band width. (Upper Bollinger Band Value – Lower Bollinger Band Value) / Middle Bollinger Band Value is the straightforward method for calculating Bollinger Band width (Simple moving average).
Using daily charts, it is hypothesized that when the indicator approaches its lowest point in six months, volatility would start to rise. This brings up the previously mentioned tightening of the bands. The Bollinger Band indicator frequently signals a significant move by squeezing.
Additional indicators can be used, such as the volume growing or the accumulation distribution indication going on.
These additional signs provide additional proof of a possible Bollinger Band squeeze.
When trading a Bollinger Band squeeze, we need to have a competitive edge because even the most experienced traders can be fooled by these setups.
Difference between Bollinger Bands and Moving Average Envelopes
Bollinger Bands, where highs are close to the upper line and lows are close to the lower line, represent the levels of various highs and lows that a security price has attained over a specific period of time as well as its relative strength. In other words, the price points close to the boundaries of the constructed “envelope” can aid in the recognition of a pattern at a specific time. Depending on the volatility, the bandwidth can become wider or narrower. The band would go wider if it were high, and it would get narrower if it were low. In relation to a chosen time period moving average, these bands display oversold and overbought circumstances.
Moving average envelopes and Bollinger Bands are similar in certain ways, but the mathematics used to create each are different. In Bollinger Bands, the upper and lower lines are drawn using the standard deviation levels, but in Moving Average Envelopes, the lines are plotted using a predetermined percentage.