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Mastering Trading Strategies with Bollinger Bands

kokou adzo

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The invention of the Bollinger Bands indicator is credited to American analyst John Bollinger, who set out in 1984 to create his own system for investment analysis and calculations. After spending about seven years on this endeavor, Bollinger introduced his system to the investment and trading community in the early 1990s. His indicator quickly gained popularity among market participants, being adopted by many traders and still widely used today. Presently, John Bollinger is the owner of the financial company Bollinger Capital Management Inc., which utilizes the methods he developed.

The idea behind Bollinger Bands is to combine a trend indicator, volatility indicator, and oscillator into one. The bands depict on the chart the direction and range of price fluctuations, considering both the trend and volatility characteristic of the current market phase. Graphically, the indicator consists of three lines: a moving average in the middle, representing the main direction of movement, and two lines limiting the price chart on both sides, characterizing its volatility.

The upper and lower lines are the same moving average but shifted by several standard (root-mean-square) deviations. Since the standard deviation depends on volatility, the bands adjust their width: it increases when the market is unstable, for example, during news releases, and decreases in more stable periods. Thus, the indicator incorporates oscillator functions in a more convenient form, allowing traders to assess the overbought or oversold condition of an instrument directly on the chart, taking into account the amplitude of fluctuations.

Utilizing Bollinger Bands in Forex Trading

In addition to their application in traditional trading setups, Bollinger Bands are widely employed in Forex funding strategies. Traders often use these bands to gauge currency pair volatility and identify potential entry and exit points in the forex market. The adaptive nature of Bollinger Bands, adjusting to market conditions by expanding and contracting based on volatility, makes them particularly suitable for forex trading. By incorporating Bollinger Bands into their forex funding strategies, traders can better navigate the dynamic forex market environment and capitalize on trading opportunities with improved precision and confidence.

Method of Calculating the Moving Average

It is worth choosing a method of calculating the moving average that will most clearly reflect price movements in history. In Quik, the following types of averages are available: simple, smoothed, exponential, and volume-adjusted.

To calculate moving averages, closing prices (close), opening prices (open), high prices (high), low prices (low), median = (high+low)/2, and typical = (high+low+close)/3 can be used. It is recommended to use close or typical prices.

Setting Up the Indicator

The main rule when constructing Bollinger Bands is the following statement – about 5% of prices should be outside these lines, and 95% inside. At the same time, the price should periodically touch the channel boundaries, and during sharp movements, a brief exit of the chart beyond the boundaries is permissible.

Period and Standard Deviation

Bollinger himself recommended using a 20-period simple moving average as the middle line and 2 standard deviations to calculate the band boundaries. As a rule, the period is set from 13 to 24, and the deviation from 2 to 5. Also, round values ​​such as 50, 100, 200, or Fibonacci numbers can be used as periods. It should be noted that the higher the period, the lower the sensitivity of the indicator and the more lag there will be. On instruments with low volatility, such settings will make the indicator useless.

Bollinger Bands Exhibit the Following Characteristics

If the channel boundaries diverge, it indicates the continuation of the prevailing trend, whereas if the outer Bollinger Bands narrow, it may suggest the trend is weakening and a possible reversal.

Movement initiated from one of the boundaries is likely to continue to the other.

The position of the price chart relative to the middle line indicates the trend direction. If the chart is above it, the trend is upward, and vice versa. Additionally, the line itself should also be oriented in the corresponding direction.

Methods of Using Bollinger Bands in Trading

  • Buying/selling with the trend after pullbacks. When an instrument is in a stable trending phase, Bollinger Bands help identify the point at which it’s safest to enter after a pullback. Typically, in an uptrend, the price chart is situated between the middle and upper Bollinger Bands. Therefore, buying when the price retraces and approaches the lower band is favorable. A good confirming signal is if the price builds a horizontal correction rather than a zigzag one at this point. In such cases, there’s a higher probability of a profitable trade, and a short stop loss can be placed below the consolidation support. Exiting for profit can be done when the price crosses the middle line in the opposite direction or reaches other target points. The same applies to a downtrend.
  • Sharp price changes often occur after the Bollinger Bands contract due to decreased volatility. Quite often, before a strong movement, the instrument experiences low volatility. During these times, there’s uncertainty, preventing buyers or sellers from taking control and significantly moving the price. When certainty arises (such as due to news, breaking an important level, or the entry of a large player), those on the wrong side are forced to hastily close their positions, resulting in an impulse movement.

On the chart, this situation corresponds to the contraction of the Bollinger Bands before the movement. Here, the indicator doesn’t provide direction but indicates the moment to be attentive and look for an entry point. Typically, if after the contraction the price breaks one of the outer bands, the movement will continue in that direction. However, such a signal can significantly lag, so it’s advisable to use additional entry signals.

  • Recognition of “double top” and “double bottom” patterns. Bollinger suggests using his bands for more accurate identification of classic technical analysis patterns. For the “double bottom” pattern, the first low should be below the lower band, and the second one should be at or above the lower band. Additionally, a decrease in volume at the second low serves as an additional signal. A similar analysis is conducted for the “double top” pattern.

Besides these common methods, many trading systems use combinations of Bollinger Bands with other indicators such as RSI, MACD, MFI, Parabolic SAR, and others. Bollinger himself even suggested constructing bands not for the price chart itself but for the RSI chart and using the resulting signals. Thus, Bollinger Bands offer ample scope for constructing various trading systems and are recommended for mastery.

In conclusion, Bollinger Bands are a versatile and powerful tool in the arsenal of traders, offering valuable insights into market dynamics and potential trading opportunities. Whether used independently or in conjunction with other indicators, Bollinger Bands provides a comprehensive framework for analyzing price movements, identifying trends, and determining entry and exit points. By understanding and implementing the various methods of utilizing Bollinger Bands discussed above, traders can enhance their trading strategies and improve their chances of success in the dynamic world of financial markets.

 

Kokou Adzo is the editor and author of Startup.info. He is passionate about business and tech, and brings you the latest Startup news and information. He graduated from university of Siena (Italy) and Rennes (France) in Communications and Political Science with a Master's Degree. He manages the editorial operations at Startup.info.

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