ou have many technical tools in your toolbox until now. But one more never hurts anyone.
After you have all these skills for using different tools, you will be able to select and adapt the ones you need for every market situation.
Let’s see what we have in the bag for today:
Bollinger bands are an indicator that looks like an envelope curve, developed by John Bollinger, and allows you to compare the dynamics of certain price levels over a period of time.
Using this you can determine the market’s volatility and identify “overbought” or “oversold” conditions.
The envelope curves consist of two bands – upper and low. They are plotted at a certain percentage above and below the main moving average, which corresponds to the level of the standard deviation.
Usually, the default of charting platforms is set at a 20-period length, but you can always experiment and apply different moving average lengths on your chart.
You didn’t read the previous sentence, did you?
Because you are still stuck with “standard deviation”. You are facepalming right now.
The term standard deviation (SD) shows how far the measurements differ from the average or how to spread out numbers are.
It depends if the upper and lower bands are 1 standard deviation, then 68% of price moves that have happened recently are CONTAINED within these bands.
Another case is if the upper and lower bands are 2 standard deviations, which will mean that about 95% of price moves that have happened recently are CONTAINED within these bands.
As you can see, the higher the value of SD you use for the bands, the more prices the bands “capture”.
Settings can be adjusted to suit the characteristics of your trading style.
Which are Bollinger curve parameters:
– time period – the period which we will analyse (in days, weeks, etc.);
– deviations – the standard deviations to which the upper and lower bands will be shifted;
– horizontal line – number of periods for which the indicator changes. For example, if we enter the number 5, we change the indicator 5 periods to the right;
– method – the method for calculating the moving average (simple, exponential);
– price field – select whether the price is open, high, low, close.
If the parameters of the SMA change, then the two bands will be affected as well. If the parameters of the upper or lower band are changed separately, only they will be affected.
Because the distance between the bands is based on the standard deviation of the price, the bands widen when the movement becomes more erratic (more variable) and contract when it becomes less variable.
In other words, if the market is quiet, the bands are close to each other, but if the price moves up, the bands start to widen.
Bollinger notes the following characteristics of the bands:
- after a narrowing of the bands, sharp changes in prices usually appear as a reflection of variability;
- when prices move outside the bands, this implies an extension of the trend;
- peaks/troughs reached outside the bands followed by peaks/troughs made within the bands, cause the trend to reverse.
Let’s take a look at out first chart again.
The upper and lower bands measure volatility or the degree in the variation of prices over time.
The width of Bollinger bands is correlated to market volatility, so they automatically change in different market conditions.
With increasing market volatility, Bollinger Bands are expanding.
With declining market volatility, Bollinger Bands are narrowing.
The Bollinger Bounce
The most important thing you need to remember about Bollinger Bands is that price tends to return to the middle of the bands.
Look at the following case:
If the price moves up and reaches the upper band of Bollinger, but bounces off it, then a reversal of the last movement can be expected – a potential entry for a short position.
As you can notice, after touching the upper band, the price went back down towards the middle area of the bands.
If the price moves down and reaches the lower band, but bounces off it, then the reversal of the last movement can be expected – a potential entry for a long position.
Simply said, Bollinger bands act like dynamic support and resistance levels.
That’s why the price bounces from them.
The longer the time frame you are in, the stronger these bands tend to be.
REMEMBER: This strategy is appropriate for use when the market is ranging and there is no clear trend.
You MUST avoid trading the Bollinger Bounce when the bands are expanding!
It is dangerous because this usually means the price is not moving within a range but in a TREND!
Instead, look for these conditions when the bands are stable or even contracting.
Are you ready for some shocking news?
We left the desert for the end of our lesson.
The sweetest part is the easiest one!
Does Bollinger Squeeze occur when the bands SQUEEZE together?
Yes! As simple as that.
But what does all this squeezing mean?
It usually means that you have to prepare yourself for the upcoming breakout.
If the candles start to break out above the UPPER band, then the price will usually continue to go UP.
If the candles start to break out below the LOWER band, then the price will usually continue to go DOWN.
You enter a long position when the price breaks and closes above the upper Bollinger Bands.
You enter a short position when the price breaks and closes below Bollinger’s bottom line.
If you look at the chart above, you can notice those bands squeezing together. They seem like they want to hug each other desperately.
The price has just begun to break out of the upper band. But will they succeed in hugging?
Nope, after the price breaks out, it continues to go up, then the bands start to expand.
Using this strategy is one of the best ways to catch a move as early as possible.
However, setups like these don’t occur every day. You might see them a few times during the week especially if you are looking at a 15-minute chart.
You are impatient to go and play with your new tool. Then, do it! Experiment with how these Bollinger bands change.