Most novice traders undergo similar phases. After learning the chart basics, they fall in love with various indicators, often cluttering their charts to the point that they look like an unorganized mess. Finding indicators that prove that less is more is the next logical step in the trading journey.
This article will explore Bollinger Bands — a popular volatility indicator that conveys a lot of information through three simple lines. It will explain how it works and how to use them to trade smarter.
What Are Bollinger Bands?
Bollinger Bands are a technical indicator that helps to identify potential support and resistance levels in the market.
They got the name after the analyst John Bollinger, who created this composite indicator by combining a simple moving average with standard deviation — essentially enveloping the average price with average volatility for an upward or a downward move.
Most traders use this indicator to gauge the market’s volatility. By observing the band's positioning, they can quickly determine whether the market is in its quiet (ranging) phase or in a volatile (trending) phase.
Although Bollinger Bands lag the price movement, they’re a helpful, time-saving indicator and usually part of a more elaborate trading system.
How to Calculate Bollinger Bands
Bollinger Bands consist of three lines. The middle one is a simple moving average (SMA) — usually a 20-period one, which is a derivation of price movement over the last 20 units of time.
The upper and lower bands take standard deviation into account. Their calculation is as follows:
Upper Band = 20-period SMA + (20-period standard deviation of price x 2)
Lower Band= 20-period SMA – (20-period standard deviation of price x 2)
Although Bollinger and other early adopters used to do these calculations manually, nowadays Bollinger Bands are regularly included as a built-in indicator in trading software packages.
What Do Bollinger Bands Indicate to Traders?
Bollinger Bands are a tool for the market’s volatility evaluation. Although they can serve multiple purposes, their main two uses are to tell whether the market volatility is contracting or expanding.
The Bollinger Band Squeeze occurs when the volatility drops, causing the space between the bands to tighten. This development reflects a compression in average price movement, notifying the traders that the market has slowed. It is important to remember that band narrowing doesn’t provide directional clues but simply indicates an ongoing range-bound period.
When the price closes outside of the Bollinger band (usually after the Squeeze), traders consider it a potential new breakout. More often than not, the price move will go into a trend, moving in that direction. Meanwhile, the bands will significantly expand, often diverging significantly to accommodate this fresh volatility graphically.
Benefits of Putting Bollinger Bands Strategy into Action
Bollinger Bands are a simple, visually-appealing and user-friendly indicator that gives a lot of information with one glance. They have multiple applications but are most helpful as a volatility indicator and a mean-reversion trading tool.
Setting Buy and Sell Limits
Markets spend considerable time in the range — bouncing back and forth between key levels. Bollinger bands help to identify those levels by projecting this range as a function of average volatility.
When the middle band (moving average) flattens, it indicates the high likelihood of a wide market. Traders often use buy and sell limit orders at enveloping band, trading against those short-term rallies and expecting the price to fall back at least to the moving average. This trading style is known as mean-reversion trading.
Bollinger Bands measure volatility using standard deviation. Therefore, the distance between the bands increases or decreases with price movement — widening when the volatility increases and constricting when it decreases. Even a novice trader can get a lot of information just from the position of bands.
Traders might prefer breakout strategies when the volatility is high but ranging strategies when the volatility is low.
Limitations of Bollinger Bands
Bollinger Bands can be a valuable part of any trader’s toolbox, but they come with a few limitations. First and foremost, they’re a lagging indicator. They react to changes in price and don’t predict them — essentially offering one glance interpretation of recent price events.
Yet another limitation is the fact that Bollinger Bands don’t work equally well in all conditions. They tend to perform better in ranging markets, indicating that the price has deviated from the mean and might start reverting.
Finally, Bollinger Bands standard settings (20 for period, two for standard deviations) might not be suitable for every asset. Forex traders who prefer exotic pairs with higher volatility might opt for different settings than those focusing only on a few major pairs.
A Trading Strategy for All Market Conditions
For over four decades, Bollinger Bands have been a valuable part of traders’ systems. Despite being a lagging indicator, they offer information about volatility and key levels through three lines.
Whether for long-term or short-term trading, this indicator is not a standalone system, and it falls to an individual to find the most suitable way of unlocking its full potential.
Frequently Asked Questions
What are the three Bollinger Bands?
Bollinger Bands indicator consists of three bands: middle, upper and lower. The middle one is a moving average, while the upper and lower ones mark a certain number of standard deviations away from the price — showing implied volatility of a possible move up or down.
What should I set my Bollinger Bands to?
Most common settings are 20 for the period and two for standard deviations. Twenty periods mean looking at the average price movement over the last 20 candles, while two standard deviations take 95% of the data into account as a possible move above or below.
Are Bollinger Bands any good?
Bollinger Bands are a lagging indicator and cannot serve for price predictions. However, they’re useful for measuring volatility and detecting its compression. They can be a valuable part of a more comprehensive trading system.