What are Bollinger Bands

31 August 2020

    Bollinger Bands is a statistical chart indicator used for financial technical analysis. Bollinger Bands took their name from its creator, John Bollinger, who introduced the indicator in the 1980s. Bollinger Bands is a widely used technical analysis indicator, used by traders in manual trading and automated strategies, and its main purpose is to provide information about price and volatility of the underlying symbols like stocks, currency pairs and crypto assets. You can find the Bollinger Bands indicator in all popular trading platforms offered by any CFD broker, including Fondex cTrader. In this article we will explain how Bollinger Bands are calculated, what they represent, and how they are used in different trading strategies, with examples taken from Fondex cTrader charts.

     

    How are Bollinger Bands Calculated

     

    Bollinger Bands are composed of three lines (bands) plotted on the chart. These lines are 

     

    1. Middle Bollinger Band - A moving average of the price, usually the simple moving average of the candlesticks closing prices.

       

    2. Upper Bollinger Band -  An n-times standard deviation of the price above the moving average, for the moving average periods.

       

    3. Lower Bollinger Band - An n-times standard deviation of the price below the moving average, for the moving average periods.

       

    In the chart below we can see a typical Bollinger Bands indicator plotted on a candlestick chart in Fondex cTrader.

     

    Bollinger Bands indicator

     

    In red we can see a twenty-period simple moving average of the closing prices, and in green - the relevant upper and lower Bollinger Bands, respectively. We can notice how Bollinger Bands get wider when there is volatility in the market, and how they become narrower when the market is relatively quiet. A typical setup for the Bollinger Bands indicator is a 20 periods simple moving average and 2 standard deviations, as shown below

     

    Bollinger Bands indicator

     

    Fondex cTrader further allows you to shift the indicator back and forth, as well as to choose a different type of moving average.

     

    What do Bollinger Bands Show

     

    The main purpose of Bollinger Bands is to indicate the levels at which the price can be considered too high or too low, taking into account the average market price and market volatility at the given moment. When approaching or crossing the bands, the price starts deviating from the typical price range. In other words, when the market price approaches the upper Bollinger Band, then the market can be considered overbought, and when it approaches the lower Bollinger Band, it can be considered oversold. By calculating the standard deviation of the prices, the bands indicate the range in which the prices can be considered normal. When the price approaches or crosses one of the bands - trades are justified to expect something to happen, usually a breakout or a bounceback. 

     

    The Bollinger Band indicator does not provide any trading signals on its own. It just describes the current state of the market, and it is used by traders in context with other available information to determine the possibility of future price movements. Hence, there are different strategies based on Bollinger Bands, which combine other information to predict a possible future price movement. Below we present and explain a few of them.

     

    Bollinger Band Strategies

     

    Bollinger Bands are used successfully in several trading strategies. In the following paragraphs, we will outline some of the most popular ones, and explain how you can use them in your trading.

     

    Bollinger Bounce Strategy

     

    The Bollinger Bands bounce strategy is based on accepting the markets’ mean reversion theory. In brief, the mean reversion theory states that the price of a stock, index, currency pair on any other instrument will tend to move to the average price over time. In the Bollinger Bands context, this means that if the price is trading near the bands, there is a possibility of a reversal to the moving average after some time. In this case, the bands work as dynamic support and resistance levels. See an example of prices bouncing back to the moving average after reaching the upper end lower Bollinger Bands below.

     

    Bollinger Bounce Strategy

     

    We see that even though prices touched the upper and lower Bollinger Bands, eventually they returned to the moving average. However, the fact that the instrument price is near or has broken the bands resistance is not reason enough to expect the price to bounce back. Betting only on prices bouncing back to average might lead to a lot of false signals. Below we use the same chart to highlight cases where the price touched the upper Bollinger Band, but continued trending upwards, resulting in a false bounce back signal. 

     

    Bollinger Bounce Strategy

     

    The reason this happened is because the bounce strategy does not work well in trending markets, but is rather more appropriate for ranging markets. In the chart above, however, EUR/USD was clearly in an upward trend. If you plan to use the bounce strategy in a trending environment, make sure you are placing trades only in the direction of the trend. In the chart above, all buy trades would have had a profitable outcome. Most sell entries, on the other hand, would have had a devastating one.

     

    Bollinger Squeeze Strategy

     

    Another use case for Bollinger Bands is the identification of price breakouts. A popular strategy for this purpose is the Bollinger Squeeze. The squeeze strategy says that when there is a prolonged squeeze of the Bollinger Bands around the price movement, indicating the indecisiveness of the market, then a break out and the formation of a new trend is possible as soon as the price breaks one of the support/resistance lines, marked by the upper and lower Bollinger Bands. 

     

    In the EUR/GBP chart below we identify a prolonged squeeze of the price and demonstrate a successful identification of a breakout, following the Bollinger Bands squeeze.

     

    Bollinger Squeeze Strategy

     

    As we can see from the chart, the price was fluctuating around an almost flat moving average for a prolonged period of low volatility. As soon as the price broke the upper Bollinger Band, prices moved rapidly upwards, forming the beginning of a new trend. If we entered into a long position at the point where the price broke the upper Bollinger Band, we would have made some nice profits. This is a successful use case of the Bollinger Band Squeeze strategy.

     

    Double Bollinger Band Strategy

     

    One more strategy using the Bollinger Band indicator is the Double Bollinger Band (DBB) strategy. The DBB is a strategy that makes use of two bollinger band indicators at the same time, and it is used to identify breakouts and forming trends while evaluating the momentum and volatility of the underlying price. The DBB strategy setup consists of two Bollinger Bands plotted on the same chart. The most common setup is a Bollinger Band indicator with standard deviation of 2 and a Bollinger Band indicator with standard deviation of 1. 

     

    Below we can see an example of such a setup in Fondex cTrader

     

    Double Bollinger Band Strategy

     

    In green we can see the bands calculated with two standard deviations, and in purple - the bands calculated with one standard deviation. The area between the two upper bands is known as the Buy Zone and the area between the two lower bands is known as the Sell Zone. The area between the single standard deviation bands is named the Neutral Zone.

     

    The principle behind this strategy is that during strong trends, the price usually fluctuates within the channels formed between the purple and the green bands i.e. the Buy Zone and the Sell Zone. This is evident in the chart above, but we also highlight such trends in the chart below.

     

    Double Bollinger Band Strategy

     

    In the highlighted areas, we can see the bearish trends evolving in-between the two bands and terminating as soon as the price crosses above the moving average. This is the type of trends that the DBB strategy is trying to identify. Such price movements are usually signaled when the price breaks into the sell/buy zone, while the distance between the Bollinger Bands is increasing, indicating an increase in market volatility. Therefore, the principle is for the traders to wait for Bollinger Bands to start expanding, signaling an increase in volatility. As soon as the volatility is increased and the price breaks into one of the buy or sell zones, we have a signal to buy or sell, respectively. The exit signal for the DBB strategy is usually a candle closing back into the Neutral Zone.

     

    Bollinger Bands combined with Price Patterns

     

    Bollinger Bands can also be used in combination with other trading techniques, especially price patterns, with the bands serving as sophisticated and dynamic support and resistance levels. Usually price patterns like double top/bottom, triple top/bottom and head and shoulders are used to identify strong resistance points and price reversals. These patterns are usually spotted by identifying linear support and resistance lines. The disadvantage of using linear support and resistance lines is that market volatility is not considered in identifying the resistance level. On the contrary, by using Bollinger Bands, we can identify reversal price patterns with more accuracy, since market volatility is taken into consideration during the calculation of the bands.  In the chart below, we can see a bearish setup by the successful identification of a triple top pattern using the Bollinger Bands indicator. 

     

    Bollinger Bands combined with Price Patterns

     

    We can notice how the price tried to penetrate the upper Bollinger Band unsuccessfully three times, forming a triple top pattern. After that a bearish reversal was initiated leading into an extended bearish trend. In a similar way to the triple top pattern, the bands can be used to spot other reversal patterns as well.

     

    Concluding, the Bollinger Bands indicator is a versatile tool that can be used in several ways in successful trading strategies. It is a popular indicator and will certainly be offered by your CFD broker platform. By using Bollinger Bands, traders can identify breakouts, trends and reversals, as well as assess the state of the markets and establish if they are in a trending state or in a consolidation phase. Fondex is one of the few CFD brokers that offers the Bollinger Bands indicator with a variety of additional settings for both manual and automated trading, so you are free to adopt this powerful tool to your own personalized needs.

     


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