Bollinger Bands: Definition, Interpretation and Trading Strategies

What Are Bollinger Bands?

Bollinger bands are a technical indicator that helps traders determine market volatility and potential entry and exit points.

It consists of three lines plotted on a price chart: a middle line, an upper band, and a lower band. The middle line is a simple moving average (SMA), and the upper and lower bands are standard deviations away from the SMA.

These bands expand and contract based on market volatility, providing a visual representation of price action in relation to volatility.

Bollinger Bands Calculation

Generally, you don’t have to worry about calculating the Bollinger bands. Most online trading platforms usually implement them as a tool to use. You simply have to launch it and choose the settings you prefer.

However, if you’re curious to know, the Bollinger Bands calculation is straightforward.

First, you calculate the simple moving average (SMA) of the asset's price over a specified period, typically 20 days.

The upper and lower bands are then set two standard deviations away from this SMA.

This calculation method allows Bollinger Bands to dynamically adjust to the market's volatility, making them generally reliable.

Bollinger Bands Settings

The default settings for Bollinger Bands are a 20-day period for the SMA and a 2-standard deviation distance for the bands.

However, these settings can be customized depending on your trading style and the asset you are analyzing.

Adjusting these settings can provide different perspectives on the market, so it's crucial to test and optimize them based on your strategy.

Bollinger Bands vs. Moving Average

While Bollinger Bands are based on moving averages, they offer more information than a simple moving average (SMA).

A moving average provides a smoothed line representing the average price over a specific period but doesn't account for volatility.

On the other hand, Bollinger Bands incorporate volatility into their structure, making them a more versatile tool for technical analysis.

How to Interpret the Bollinger Bands

Now that you know the Bollinger bands, it’s important to understand how this indicator can help you in your trading.

To use within your trading strategies, you must understand what it signifies. Here’s a simple Bollinger Bands interpretation:

Moves Within the Bands

First, when analyzing a price chart with Bollinger Bands, you'll often observe that prices fluctuate between the upper and lower bands.

These bands act as dynamic support and resistance levels, where the price tends to "bounce" off the bands.

Therefore, by noticing the price movements via these bands, the following can be deduced:

• Consolidation Phase: Prices between these two bands typically indicate a consolidation phase. So, the asset is trading within a relatively stable range, with prices neither sharply trending upward nor downward.

• Oversold Condition: Prices approaching the lower band indicate an oversold position. This can be used as a potential buying opportunity.

• Overbought Condition: Prices approaching the upper band indicate an overbought position. This can be used as a potential selling opportunity.

Signals at the Upper Band

Having understood the general interpretation of price movements using Bollinger bands, let’s explore what price actions near the upper band specifically indicate.

When the price touches the upper Bollinger Band, it may signal that the asset is overbought.

An overbought condition means that the price has risen higher than its recent average, suggesting that it may be due to a pullback or reversal.

Moreover, in a range-bound market, the upper band often serves as a sell target for mean reversion traders. These traders expect the price to return to the recent average's middle band.

However, in strong uptrends, prices may stay above the upper band longer, signaling ongoing buying pressure. Therefore, it's important to approach this signal with caution.

While a touch on the upper band can indicate a potential reversal, it’s important to confirm it with other indicators, such as the Relative Strength Index (RSI) or Moving Average Convergence Divergence (MACD).

Signals at the Lower Band

While the upper band suggests overbought conditions, the lower band suggests oversold conditions.

An oversold condition means the price of an asset has dropped below its recent average. This may indicate that the asset is undervalued, signaling a potential buying opportunity or a pause in the downtrend.

Increased volatility often accompanies a price hitting the lower band, particularly in a downtrend.

This could suggest continued bearish sentiment, especially if the price stays below the band for an extended period.

However, just like with the upper band, it’s very important to confirm with other indicators to avoid incorrect decisions.

What Widening Bands Mean

As we mentioned above, the Bollinger Bands can help determine market volatility through the widening and tightening of the bands.

Widening Bollinger Bands indicate that market volatility is increasing. This happens when the price starts to deviate more from the moving average, causing the distance between the upper and lower bands to expand.

Such widening typically follows major events like economic reports or earnings announcements and often signals the start of a significant price trend.

Moreover, if the bands widen after a period of narrowing, known as a "squeeze," it often signals an upcoming breakout. While Bollinger Bands doesn't indicate the direction, analyzing price movements with other indicators can help predict it.

This is usually a very important moment to monitor the market closely, as the increased volatility could offer significant trading opportunities.

What Tightening Bands Mean

On the other hand, when Bollinger Bands tighten, it indicates that market volatility is decreasing. This often shows that the market is in a consolidation phase with limited price movement.

The tightening of Bollinger bands typically precedes significant price movements–the calm before the storm–making it an important trading signal.

A prolonged squeeze suggests the market is building momentum for a potential breakout. The longer the squeeze lasts, the more powerful the subsequent move is likely to be.

However, predicting the direction of the breakout can be tricky, so you must use other indicators to make better-informed decisions.

Bollinger Bands Trading Strategy

Bollinger Bands can be integrated into various trading strategies to help identify optimal entry and exit points.

Here are a couple of strategies that utilize Bollinger Bands effectively:

1. Trading the Bollinger Bands Bounce

The Bollinger Bounce strategy is based on the principle of mean reversion, which suggests that prices will return to their average levels after reaching the extremes marked by the outer Bollinger Bands.

Steps to Trade the Bollinger Band Bounce

1. Identify a Range-Bound Market: Ensure the market isn't trending strongly in either direction. This strategy works best when prices oscillate between established support and resistance levels.

2. Monitor the Lower Band: Consider entering a buy position when the price touches the lower Bollinger Band, expecting a bounce back toward the middle band (the moving average).

3. Set a Target Near the Upper Band: After entering a buy position, aim to exit or sell near the upper band, where the price is likely to face resistance and potentially reverse.

4. Repeat the Process: In a stable range-bound market, you can continue this strategy, buying at the lower band and selling at the upper band as long as prices stay within the range.

Bollinger Bounce: Stop Loss and Profit Target

In this trading strategy, as mentioned above, your profit target should be set near the upper Bollinger Band. As the price approaches this level, it is expected to face resistance, which might cause it to reverse or consolidate.

Exiting the trade at or near the upper band allows you to capitalize on the anticipated price bounce while avoiding potential reversals.

Moreover, when you enter a buy position after the price touches the lower Bollinger Band, you must set your stop-loss just below the lower band.

This acts as a safety net in case the price doesn’t bounce back as expected and instead continues to fall.

2. Trading the Bollinger Bands Squeeze

The Bollinger Squeeze strategy capitalizes on the potential for significant price movements following periods of low volatility, signaled by the bands tightening or "squeezing" together.

Steps to Trade the Bollinger Squeeze

1. Identify a Squeeze: Look for periods where the Bollinger Bands have tightened significantly, indicating reduced volatility and a potential breakout on the horizon.

2. Monitor Additional Indicators: Since the Bollinger Bands alone don’t indicate the breakout direction, use additional indicators (RSI, MACD) to know whether the price is more likely to break upward or downward.

3. Prepare to Enter a Position: As the breakout begins, enter a trade in the direction suggested by your analysis. For instance, if indicators suggest an upward breakout, consider entering a long position.

Bollinger Squeeze: Stop Loss and Profit Target

The profit target in a Bollinger Squeeze strategy should be based on the expected strength of the breakout.

A common approach is to measure the height of the bands during the squeeze period and project that distance in the direction of the breakout.

You can also consider setting the profit target near key support or resistance levels, where the price might encounter significant barriers.

Moreover, in terms of stop loss, set your stop-loss just outside the squeeze area, either slightly above or below the tight bands, depending on the direction of your trade.

For example, if you anticipate an upward breakout and enter a long position, place the stop-loss just below the lower band of the squeeze.

Common Mistakes to Avoid When Using Bollinger Bands

While Bollinger Bands are very helpful in technical analysis, traders can sometimes make mistakes that lead to less effective outcomes.

Here are some of these common mistakes to avoid:

• Using Bands Alone: Don’t rely solely on Bollinger Bands. Always confirm signals with other indicators like RSI or MACD.

• Misreading Overbought/Oversold: Remember, prices can stay at extremes in strong trends, so consider the broader market context.

• Ignoring Market Conditions: Adjust your strategy for trending vs. range-bound markets to avoid poor decisions.

• Default Settings: Customize settings based on the specific asset and market to enhance effectiveness.

What Are the Benefits of Using Bollinger Bands in Technical Analysis?

Using Bollinger Bands presents the following benefits:

• Measures Volatility: Adjusts to market volatility, offering a clear view of price fluctuations.

• Identifies Trends: Signals potential trend reversals at the upper and lower bands.

• Versatile: Works across different asset classes and time frames.

• Supports Mean Reversion: Highlights trading opportunities in range-bound markets.

What Are the Limitations of Using Bollinger Bands in Technical Analysis?

Despite its benefits, trading the Bollinger Bands has the following limitations:

• False Signals: Can produce misleading signals in trending markets.

• Lagging Indicator: Reacts slowly to sudden market changes.

• No Directional Clarity: Doesn’t indicate the direction of potential breakouts.

• Needs Complementary Indicators: Often requires other tools for accurate analysis.

Conclusion

Bollinger Bands are an important technical analysis indicator for traders looking to capitalize on market volatility.

Whether you're using the Bollinger Bounce or the Bollinger Squeeze strategy, understanding how to apply this indicator can significantly improve your trading approach.