What are Bollinger Bands?
Bollinger Bands are two standard deviation lines drawn in parallel to a simple moving average. The bands move parallel, in tandem, with the moving average. The two main applications of the bands are to identify — consolidation, by Bollinger band squeeze and the overbought and oversold condition in a sideways market. The most commonly used SMAs in Bollinger bands are 20 and 25. It was named after its developer John Bollinger.
The bandwidth of the Bollinger bands
The difference between the upper band and the lower band is the bandwidth.
The bandwidth represents the maximum volatility or the range of the market at that particular instance.
The bands are not constant values; they expand and contract based on volatility.
If the volatility is high, the bands expand and if the volatility is low, the bands contract. Bollinger band is one of the finest indicators to denote volatility.
Why use Bollinger Bands?
They have different applications in different scenarios.
The moving average helps to identify the trend.
The Bollinger band squeeze and contraction identify the consolidation.
Above all, it identifies the overbought and oversold condition in the sideways market.
Case #1 – Moving Average
You can use moving average to either identify the trend or to trade. And, the Bollinger band is the icing on the cake in both cases.
The forex market is volatile and erratic. Hence the price action tends to cross the moving average in many instances. And in most cases, these breakouts end up as fakeouts. Hence, a trader should always have a room of 10-20% deviation on the moving average which the bands facilitate.
In the above example, if you were using the 20-SMA as a standalone indicator, you would have been stopped out as soon as the price breached the moving average. And the price would have resumed its rally, to your frustration. However, a 20% standard deviation could have made the day for you. And the Bollinger bands provide this perfect buffer a trader needs.
Case #2 – Overbought and Oversold conditions
The overbought condition is usually the state when an asset had overrun and stays precariously at the top. The oversold condition is the vice-versa. These conditions are easy to trade with the RSI indicator when they surface during a trend.
However, they pose a challenge when they occur during the range bound move. Bollinger bands are the best to counter the sideways market.
The above image is a perfect illustration of the application Bollinger Band in a sideways market.
When the candlesticks tread above the upper band, it suggests an overbought condition in the sideways market.
Likewise, when the candlestick treads below the lower band, it implies an oversold condition.
Further, a short trade on the overbought zone and a long trade at oversold zone are quite easy to spot.
But, before pouncing on to such trades, ensure whether it is a sideways market.
Case #3- Bollinger Band Squeeze
The Bollinger Band squeeze is the best to identify the consolidation phase of the market. The other way of saying it would be one can determine the strength of the trend with band squeeze.
The bands expand to the greatest during a breakout. And they maintain a consistent distance, like a price channel, in a trend move. However, when they contract and squeeze, it signifies an area of caution. It implies the market is going through a consolidation phase and trend might reverse.
It is imperative to understand the Bollinger band squeeze is a double-edged sword — although a correction usually follows, it isn’t customary.
Implications of Bollinger band squeeze
- The Bollinger band squeeze signals the beginning of consolidation.
- It is best to avoid trading during the squeeze.
- The break out results in a robust trend move. Hence, entering at the outset of a break out is high yielding and less risky.
Example #1 – Trend reversal with Bollinger Band squeeze
In the above image, after a good upmove, the USD/CAD consolidates within the Bollinger Band squeeze. For a conservative trader, this is a no-trade zone.
Subsequently, a break out happens, against the trend, signaling either a pullback or trend reversal. A short trade initiated at the break out would have yielded handsome profits.
Example #2 – Trend continuation with Bollinger Band squeeze
Here, the market starts off a downtrend move initially and then consolidates within a Bollinger Band squeeze. Further, the squeeze happens for a prolonged period. The price action breaks the squeeze with a strong bearish candle which validates the breakout. A short traded initiated with a tight stop above the candle high would’ve created a fortune.
Example #3 – Multiple opportunities with Bollinger Band squeeze
In the above example of EUR/JPY, the Bollinger band contracts and squeeze after an impulse move. The band squeeze is then followed by a reversal in the initial case. But, continuation moves followed the subsequent band squeezes. So, if you’re spot on in spotting the band squeeze you could have a profit spree too.
A simple yet powerful technique
Go long or short at the breakout of the Bollinger band squeeze.
Keep a tight stop loss just 5-10 pips above/below the candlestick that rendered the breakout.
Set a target twice or thrice the stop loss value.
Ta-da, you’re in for a treat!
How to use Bollinger Bands wisely?
This is the part most traders get wrong. Amateur traders tend to ‘assume’ every wick above the band as overbought zone and go for short trades (vice versa for ‘assumed’ oversold zone). As mentioned above, the Bollinger Bands comes into play in the overbought and oversold in the sideways market and not so well in directional moves.
Scenario #1 – Trade the Trend
Use the Bollinger Bands to spot the entry points in a retracement move.
During an impulse move, they will be on a slope of 20 degrees or above.
And, the market retraces to the midline(moving average), which is your entry points.
When the price reaches the upper band (the lower band for the downtrend), it exerts selling pressure. Hence, the upper band is your exit point. Trade with the notion that the midline is to hold rather than break. And, always play to your strengths, but how?
In the above example, the currency pair is in a downtrend. It makes a pullback to the 20 SMA, which entices the bears to initiate a short trade. The exit point is the lower band. As you can see, the strategy presents numerous trade opportunities if the trend persists for a prolonged period.
Note: It is better to exit the trade if the Bollinger band squeeze.
Scenario #2 – The King of Sideways Market
When all indicators fail in the sideways market, you can find a resort in the Bollinger Band. It identifies the overbought and oversold condition of the sideways market with ease. In an overbought condition, traders short the currency pair. Likewise, traders go long in an oversold condition.
The above chart is an example of a sideways market. Initiating a short position at the ‘flattened upper band’ and long trade at the ‘flattened lower band’ are the ideal trades in a sideways market. When the wicks peek out of the flattened bands, it intimates an entry point, which endorses a high success rate. As long as the market remains zig-zag, the bands’ relevance and application are of prominence.
Bollinger bands are two lines drawn parallel to a moving average.
They expand and contract based on price action and volatility.
Overbought- If the price is outside the upper band.
Oversold- If the price is outside the lower band.
When the Bollinger band squeeze it signals a consolidation. The breakout may be towards or against the trend.
The commonly used SMAs are 20 and 25.
Bollinger Band is ‘the jack of all conditions, but the king of the only sideways market.’ Hence to apply it in a wide range of market conditions, it is best to combine the bands with indicators like MACD or with harmonic patterns like ABCD chart pattern.