Learning to trade with Bollinger bands

Bollinger bands are a widely used technical analysis tool offering traders a visual means to assess market volatility and price levels. This article explores the complexities of Bollinger bands, starting with their conceptual framework and calculation, which incorporates moving average and standard deviation lines. We then discuss practical techniques for employing Bollinger bands in trading scenarios, including various strategies that utilize the bands to make informed trading decisions. 

We also explore the advantages and limitations of Bollinger bands and provide an insider perspective on enhancing their effectiveness by combining them with other market indicators. Finally, we evaluate the overall efficacy of the Bollinger bands as a standalone indicator in today's dynamic markets. Whether you're a novice or a seasoned trader, understanding Bollinger bands can be a valuable addition to your trading arsenal.

Content:

What are Bollinger bands?

Bollinger bands are a technical indicator developed by John Bollinger, CFA, CMT. It consists of an upper band, a middle band, and a lower band.

The green line is the upper band, the grey line is the middle band or simple moving average, and the blue line is the lower band.

The middle band is the Simple Moving Average (SMA), set at 20 by default. When John Bollinger developed the indicator, he measured the stock price movement within a month using a daily timeframe. Hence, until today, most charting platforms set 20 as the default period.

How Bollinger bands are calculated

Middle = Simple Moving Average

Upper = Upper Band

Lower = Lower Band

x = Multiplier of the Standard Deviation (default = 2)

SD(MAi) = Standard Deviation of the Moving Average

i = The length of the observation period

The formula above is the default formula for Bollinger bands. However, in the computer era, many traders have modified the formula to optimize the indicator, mainly to produce better signals. For example, the most frequent modification is to the Moving Average formula to an Exponential Moving Average, a Weighted Moving Average, etc. Another modification is the standard deviation multiplier because it changes how traders interpret the indicator.

How to trade with Bollinger bands

Trading with Bollinger bands offers investors a sophisticated means of gauging market volatility and potential price movements. Bollinger bands are composed of three lines: the middle band, which is a simple moving average, and the upper and lower bands, which are typically set at two standard deviations away from the middle band. The width of the bands varies based on historical volatility; they widen with increased volatility and narrow when volatility decreases. When the price touches or moves above the upper band, the market may be considered overbought. Conversely, when the price dips below the lower band, it might signal an oversold condition.

Using Bollinger bands in conjunction with other indicators may enhance their effectiveness. For instance, traders may use the bands alongside moving averages to discern the direction of a trend. When the price is above a moving average, an uptrend may be indicated, while a price below suggests a downtrend. Additionally, Stochastic indicators, which measure the momentum of price movements, can help pinpoint overbought or oversold territories, similar to Bollinger bands. The Average True Range (ATR) is another useful tool for gauging volatility; a higher ATR implies more volatility and vice versa. Lastly, Keltner channels, which also reflect market volatility and are based on the average true range, use a different number of standard deviations from the middle band.

To use Bollinger bands effectively, one must observe the interaction between price and the bands. For instance, if the price consistently reaches the upper band, it indicates sustained buying pressure. Alternatively, if the price frequently interacts with the lower band, it suggests persistent selling pressure. However, overbought or oversold conditions alone do not guarantee a reversal. This means traders should look for additional confirmation, such as a crossover above or below the middle band or divergences with other indicators. The bands are dynamic, contracting and expanding with the ebb and flow of market volatility, offering traders a visual representation of the potential pressure points where the price may exhibit a significant response.

Bollinger bands trading strategies

Traders widely use the Bollinger bands technical analysis tool to determine entry and exit points, assess volatility, and identify potential reversals or continuations in price trends. These bands consist of a middle line, typically a moving average, and two outer lines that represent a number of standard deviations above and below the average. Below we explore various Bollinger bands trading strategies, providing insights on how to use Bollinger bands effectively in different market conditions.

Riding the bands

When the price is consistently touching or moving along the upper band, it signifies a strong uptrend; conversely, if the price is hugging the lower band, a downtrend is indicated. In the "Riding the bands" strategy, rather than seeing these touches of the bands as signals to counter-trade, traders should recognize the strength of the trend and consider joining it until signs of reversal or weakening emerge. It's important to note that during a period of strong momentum, the price can travel along the bands for an extended time.

Bollinger band squeeze

The Bollinger band squeeze strategy utilizes the width of the bands to gauge upcoming volatility. A narrow bandwidth suggests a period of consolidation and is indicative of a potential breakout. Traders should pay attention to the subsequent expansion of the bands, as this can signal the start of a significant price move; the direction of the breakout, above or below the bands, often sets the tone for a new trend.

Breakout strategy

A breakout strategy involving Bollinger bands looks for when the price makes a decisive move above the upper band or below the lower band. With this strategy, traders typically employ a 20-period moving average and set the bands at two standard deviations from it. A move above the upper band signals bullish momentum and an opportunity for an entry point into a long position. Conversely, a move below the lower band can be a sign to enter a short position, marking bearish momentum.

Range trading strategy

The range trading strategy with Bollinger bands hinges on technical analysis to spot potential reversals after the price reaches the upper or lower extremes. When the upper band is touched or breached, the market may be considered overbought; similarly, contact with the lower band can signal an oversold condition. Traders should look for additional confirmation, such as a reversal candlestick pattern, before taking a position against the prevailing trend. However, this strategy will work best during a sideways period, which can happen approximately two-thirds of the time.

Advantages and disadvantages of using Bollinger bands

The key advantage of using Bollinger bands is the complete package that the indicator can offer. Let me explain.

As the main usage of Bollinger bands combines all the bands, the indicator offers the indication of a trend (middle band) and the potential price limitation (upper and lower bands). Hence, if the middle band points upward with a widening gap between the upper and lower bands, one can open a long position after a trigger (i.e., candlestick patterns, etc.) and aim for the upper band for the Take Profit, with the Stop Loss below the lower band.

However, utilizing the method mentioned will not allow one to trade properly during choppy markets, as it only applies to trending markets. Modifying the method by buying at the lower band and selling at the upper band during choppy markets may maximize the results.

The indicator comprises calculations of a series of prices, so the results tend to lag. Many traders think the indicator is ineffective because of the lag. However, the lag could be good as it may have eliminated some unnecessary noise in the market.

Bollinger bands effectiveness

The Use of the Bollinger bands indicator has evolved since it was first developed and as the trading community grows. Hence, measuring its effectiveness can be tricky.

However, in the market, the sayings “Trend is a friend” and “Always follow the trend” are valid when using this indicator. The Bollinger bands indicator is trend-based but not limited to being used during choppy markets.

To determine this indicator's effectiveness, a proper set of tests, such as Backtesting, Optimization, Walk-Forward Optimization, and Monte Carlo Simulation, should be performed.

In conclusion, Bollinger bands is a powerful indicator providing methods traders can modify according to usage. However, due to its modifiability, it is quite complicated to measure the effectiveness of the indicator. It is advisable to use a proper set of tests to appropriately measure its effectiveness based on the procedure of the trader's method.