Bollinger bands are one of the most versatile technical indicators available for technicians or chartists. The uniqueness of Bollinger bands lies in the fact that it combines two main components; the trend and the volatility. The trend, as every trader knows, is one of the most important aspects when analysing any financial market. A trend in the market will determine the direction of the price. Trading in the direction of the trend, also known as trend trading, is considered to be one of the safest ways to trade.
This is due to the fact that trend trading allows traders to take positions on the side of the larger market positioning.
There are many trend-based indicators and the Bollinger Bands indicator is one of them. While the trend is important, another factor is volatility. It is widely known that markets tend to range at least 80% of the time, and the markets trend only 20% of the time. Prices seldom move in a parabolic path.
This begs the question of where to enter the trend. Surely, a trader taking a position when the markets are ranging will either have to stay in the markets for longer at a risk of a decline or a correction, or the trader will have to wait for the markets to break out from the range and resume the previous trend, or at times reverse the trend as well. Answering these two questions can be done with the help of the Bollinger bands. Only the Bollinger bands indicator can be used to address these two main questions when it comes to trading. Volatility is also an essential variable to consider when it comes to trading the markets.
Volatility often goes hand in hand with momentum. When volatility slows, you can expect momentum to also decrease and vice-versa. This is why the Bollinger bands are considered to be unique, as it helps traders to decipher a lot of market information. While there are many ways to trade using Bollinger bands, the indicator was designed to address some key concepts. These include signalling when the markets will undergo a reversal at the top and bottom of a trend as well as addressing when volatility is likely to remain high.
To understand these concepts, let’s dig a bit deeper into what Bollinger bands are all about.
What's a Bollinger Band®?
Bollinger bands, as the name suggests, is a volatility and trend indicator. The indicator is placed as a chart overlay (meaning that the indicator is plotted on the price chart). It’s comprised of three bands from which it derives the name Bollinger bands.
The Bollinger bands indicator was the brainchild of John Bollinger. Bollinger designed his indicator way back in the 1980's when computers were just getting warmed up to advanced technical analysis for financial markets.
If you look closely, Bollinger bands are not that different from other bands such as the moving average envelopes indicator, or the Keltner or Donchian channels. All these indicators fall into the category of "bands." However, by factoring in the concept of volatility, Bollinger bands take on their own uniqueness.
Bollinger bands act like volatility bands. Thus, the outer bands tend to expand when volatility increases and they tend to contract or come close when volatility falls. This visual depiction makes it very easy for the trader to understand when to trade and when to stay out of the markets.
Typically, traders stay out of the markets when volatility drops. But it also means that volatility is likely to expand again sooner and thus prepares the traders to anticipate an increase in volatility.
How are Bollinger Bands calculated?
Bollinger bands are primarily based upon a 20-period simple moving average. This 20-period SMA forms the basis for the outer bands (the upper Bollinger band and the lower Bollinger band). These outer bands are derived based on standard deviation.
The typical setting is 2%. This means that the outer bands depict a 2% deviation from the 20-period simple moving average line. Sometimes, you will find that prices tend to deviate more than 2%. This is when you can see the price falling or piercing one of the outer bands.
However, Bollinger bands quickly adjust to this new deviation based on the 20-period SMA. While the 20, 2 Bollinger band setting is generally used, traders can experiment with these values. For example, you cannot expect the same level of deviation between a currency or a Forex instrument and a commodity asset such as gold or oil.
Secondly, the settings can also change depending on the timeframe that is being used. The first chart below shows an example of Bollinger bands applied to an NZDUSD chart. The default settings of 20, 2 are applied here to the daily timeframe.
Figure 1: Example of Bollinger band indicator applied to the forex chart
Upon careful observation, you can notice that when price is strongly bullish or bearish, the Bollinger bands tend to expand. Similarly, when the price is moving within a range, you can see how the outer bands contract.
When looking at the 20-period moving average, you can see the inclination of this 20-SMA signalling an uptrend.
Thus, combining the information, in an uptrend, the most ideal point of entry is when the price breaks out of the range. As volatility increases, traders are able to find better entry points into a trend based on the expansion of the outer bands.
The Bollinger band's W-Bottom signals are unique. This is a phenomenon that occurs quite often. When the markets establish the "W" bottom pattern, it usually signals that a bottom is taking shape.
This pattern within Bollinger bands can be a great way to pick the lowest points in an uptrend or even signal the end of the previous downtrend.
The second chart below; Figure 2, illustrates the “W” bottom pattern in action.
Figure 2: Bollinger band “W” bottom signal
The “W” bottom pattern is formed when the price falls to a previous low at almost near the same level. Typically, when this pattern is formed, volatility tends to contract in relation to previous volatility levels.
When the price breaks out of the W-pattern, especially after a series of previous declines, you can expect the trend to change in the near term. Another validation of this change of trend is the considerable increase in volatility after the “W” pattern breaks out.
The "M" top pattern is the inverse of the "W" pattern. Here, you can expect to see the "M" pattern forming after a considerable rally in price or during an uptrend. When the "M" pattern appears, prices tend to consolidate amid falling volatility.
Then, a subsequent downside breakout from this "M" pattern signals a decline in prices.
The "M" pattern is shown in Figure 3.
Figure 3: Bollinger bands “M” signal
What's unique about the "M" pattern in this example is that it is formed within a larger downtrend, but comes after a modest price correction. Thus, it is important to know that the "M" pattern (as well as the "W" pattern) does not always have to occur at the top or the bottom of a trend.
Once the price breaks out of the “M” pattern downwards, you can see that volatility increases and stays consistent. At the same time, the slope of the 20-period SMA signals that the price is building up downside momentum.
Signal: Walking the Bands
Walking the bands is also a rather simple concept. Walking the bands occurs when momentum and volatility are the highest. Prices in this state tend to maintain the direction for a considerable period of time. When this occurs, prices tend to post highs at or above the upper Bollinger band in an uptrend or lows at or below the lower Bollinger band during a downtrend.
Traders should note that walking the bands can last only for a couple of sessions, after which momentum starts to weaken and the price eventually starts to retrace as a result.
An example of walking the bands is shown in Figure 4.
Figure 4: Walking the bands
In the above example, there are two instances of walking the bands. Starting from the left side, you can see the areas where the price consistently “walks the band” seldom falling back to the 20-period simple moving average.
This strong uptrend is formed after a brief period of low volatility. Moving to the right, we see another instance where the Bollinger bands contract only to later move in a range before strongly trending downwards. As you can see, price action has been “walking the lower band” in this instance, with lows and lower closes forming at or below the lower Bollinger band.
Bollinger Bands – Conclusion
In conclusion, the Bollinger bands indicator is a versatile technical analysis indicator. This indicator allows traders to gauge both the trend and the volatility on the price chart. Formed as an overlay, the Bollinger bands are best used to gauge when to enter into a trend as volatility is just starting to increase.
Traders can also use many other technical strategies along with Bollinger bands and build a profitable trading system.