What is Bollinger Band?
Bollinger Bands are developed by John Bollinger to identify and to take advantage of the volatility in the market. It consists of a simple moving average and two standard deviations of the same moving average known as the bands. The bands move parallel, in tandem, with the moving average. The most commonly used simple moving averages in Bollinger band are 20 SMA and 25 SMA. The two main applications of Bollinger bands are to identify – consolidation, by Bollinger band squeeze – the overbought and oversold condition in a sideways market.
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, while 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 bands are the best indicator to denote volatility.
Why use Bollinger Bands?
Bollinger Band has different applications at different scenarios. The moving average helps to identify the trend while the Bollinger band squeeze and contraction identify the consolidation. Above all, overbought and oversold condition, especially in the sideways market is identified precisely with the help of Bollinger bands.
Case #1 – Moving Average
Traders use moving average either to identify the trend merely or to trade. The forex market can be volatile and erratic at times. And the price action tends to cross the moving average in those instances. 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 Bollinger Bands facilitate.
Take the above example, for instance; the pair starts a trend move. If you were using 20-SMA, you would have been stopped out as soon as the price breached the moving average. But, Bollinger band provides the perfect cushion and confidence to a trader by filtering the noise.
Case #2 – Overbought and Oversold conditions
The overbought condition is the usually the state when a currency pair had overrun and stays precariously at the top. The oversold condition is the vice-versa. Generally, the overbought and oversold conditions are the characteristics of a trend move. But both these conditions do exist in a sideways market too. Bollinger bands define the overbought and oversold condition in the context of the sideways market and present trade opportunities also.
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, if the candlestick treads below the lower band, it implies an oversold condition. 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 ensure whether it is a sideways market or not.
Case #3- Bollinger Band Squeeze
The Bollinger Band squeeze is the best to identify a market in consolidation. The band squeeze is extrapolated to determine the strength of the trend. During a breakout, the bands expand to the greatest. The bands maintain a constant distance, like a price channel, in a trend move. When the bands contract and squeeze, it signifies an area of caution. It merely 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 bands squeeze signals the beginning of consolidation.
- It is best to avoid trading Bollinger bands squeeze.
- The break out results in a robust trend move. Entering at the outset of a break out is high yielding, but less risky.
Example #1 – Trend reversal with Bollinger Band squeeze
In the above image, after a good upmove, the USD/CAD pair consolidates within the Bollinger Band squeeze. For a conservative trader, this is a no-trade zone. A break out happens, against the trend, signaling either a pullback or trend reversal. A short trade initiated at the break out could 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. 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 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.
The takeaway from the examples
All these 3 examples suggest only one thing. Go long or short at the breakout of the Bollinger band squeeze. Keep a tight stop loss just 5 pips above/below the candlestick that rendered the breakout. Set a target twice or thrice the stop loss value.
How to use Bollinger Bands wisely?
This is the part most traders get wrong. Amateur traders tend to ‘assume’ every wick above the Bollinger 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, the Bollinger band will be on a slope of 20 degrees or above. And, the market retraces to the midline(moving average), which are the entry points. When the price reaches the upper band (lower band for the downtrend), it exerts selling pressure. Hence, the upper band is used as exit points by traders. Trade with the notion that the midline is to hold rather than break.
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.
Scenario #2 – The King of Sideways Market
When all indicators fail in the sideways market, you can find a resort in 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, Bollinger bands relevance and application is 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 can signal a trend reversal.
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 (Moving Average Convergence and Divergence) or RSI (Relative Strength Indicator).