- What Are Bollinger Bands?
- How to Use Bollinger Bands for Trading
- Bollinger Bands Strategies in Options Trading
- Bollinger Bands in Cryptocurrency Trading
- Using Bollinger Bands with AvaTrade
What Are Bollinger Bands?
This indicator was named after its creator, John Bollinger, a famous technical analyst, who created them back in the 1980s. It is made up of a simple moving average (SMA), an upper band above it (positive standard deviation), and a lower band below the moving average (negative standard deviation).
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A standard moving average plots a series of average prices which results in a smoothed-out price action line, but Bollinger Bands incorporate standard deviations to ensure price action is observed within a channel-like tunnel.
Another unique feature about Bollinger Bands is that they are quite flexible. For example, they are dynamic in the sense that they can adjust to different market conditions and to trade various financial instruments, including stocks and forex. This means that they can be an attractive tool for all types of traders.
The Bollinger Band calculations are quite easy. The middle band is calculated as a 20-day simple moving average (SMA) as below:
Middle Band = 20-day simple moving average
Lower Band = (20-day standard deviation of price x 2) + 20-day SMA
Upper Band = 20-day SMA – (20-day standard deviation of price x 2)
In this calculation, the SMA is the sum of closing prices over n periods / by n.
How to Use Bollinger Bands for Trading
The Bollinger Bands is a powerful indicator that delivers multiple trading signals for traders in the market. Most traders utilise it for market analysis, as a volatility channel, as well as a momentum tool.
As a volatility channel, traders watch the upper and lower bands for volatility cues in the market. Particularly, traders watch for the Bollinger Bands squeeze, which occurs when both the upper and lower bands converge or come together, especially after a trending period.
A Bollinger Bands squeeze or contraction implies that the underlying market is witnessing low volatility. Periods of low volatility in the market are usually succeeded by a period of high volatility, representing a lucrative opportunity for traders to catch big profits out of the resulting or expected move. A squeeze is, therefore, a period of price consolidation ahead of a breakout.
When high volatility comes into the market, the upper and lower bands of the Bollinger Bands will diverge or broaden. A bullish breakout in the market (which denotes a buying opportunity) will occur when the upper band of the indicator is breached. Similarly, a bearish breakout (which denotes a selling opportunity) will typically be confirmed by the breach of the lower band.
A valid breakout ideally happens on high volume, which implies the conviction of market participants. A squeeze does not give any directional cues on an upcoming breakout, but in some cases, traders can be biased towards the preceding price trend.
Trading breakouts with Bollinger Bands is very effective because of the risk/reward opportunity. Generally, a tighter squeeze is likely to lead to a stronger breakout. As well, the longer the squeeze, the stronger the anticipated breakout.
When opening a breakout trade using Bollinger Bands, a stop loss is placed outside the opposite band of the prior squeeze. For instance, if the asset price breaks upwards, the stop loss for the buy trade position will be placed outside the lower band during the squeeze.
When used as a momentum tool, Bollinger Bands can be used to identify overbought and oversold conditions in the market. Bollinger Bands use standard deviation in its computation, and applying it as a momentum tool allows traders to trade using the concept of mean reversion.
This is a theory that the price of an asset will tend to revert to its average price over time. For instance, if the asset price falls ‘too much’, it will tend to revert to a ‘normal’ price.
A ‘normal’ price area, in this case, is within the upper and lower bands or around the middle band. Just by watching Bollinger Bands on a chart, traders can watch price extremes or simply periods when the price has deviated so much from its mean.
Mean reversion is excellent for trading ranging markets, with the upper and lower bands acting as dynamic lines for resistance and support, respectively.
This means that traders will look to place buy orders when prices are at or close to the lower band, and they will place sell orders when prices are at or close to the upper band.
While this a great strategy for trading range-bound markets, it can be very misleading in trending markets where prices can hug the bands for prolonged periods.
In such markets, Bollinger Bands can be used as a trend-following indicator. In strong and prolonged trending markets, Bollinger Bands usually slope in the direction of the trend.
The idea in a trending market is to find easy ways to join or enter the dominant trend. This means finding quality price points after a retracement or pullback in the market.
In a strong uptrend, Bollinger Bands will slope upwards, with prices generally ‘hugging’ the upper band. The middle and lower bands will provide great price points for entry targets when there is a retracement or pullback in the market. In a downtrend, traders will look to enter trades at the middle or upper bands after a retracement or pullback.
As can be observed, Bollinger Bands is a powerful indicator, and it can be said that it was designed to “contain price”. All its bands highlight valuable price areas in the market.
But this naked information can be complemented with the trade signals provided by the MACD or the RSI, an indicator that will show trend strength and momentum at the value price areas.
For instance, in an uptrend, traders can place buy trades in the middle and lower bands when the RSI delivers oversold signals. The RSI can also give validation during breakouts by showing whether there is enough momentum for any resulting move to be sustained.
This is done by observing the centreline. If, for instance, the price breakouts below the lower band, a solid signal to sell will be given by the RSI when the indicator falls below the 50-line to signal increasing bearish momentum in the market.
When trading trending markets using Bollinger Bands, it is important to maintain a greater perspective of the overall trend as the price continues to ‘hug’ the relevant bands. This is usually done by using the double Bollinger Band strategy.
This involves using two Bollinger Bands on your chart: the first is the default indicators (the middle 20 SMA and 2 standard deviations), and the second one is the default 20 SMA but with 1 standard deviation (SD).
Using this strategy there are three interest zones generated: the buy zone, the neutral zone, and the sell zone. The buy zone is the area between the first upper SD and the second upper SD – it is located above the middle band. When the price is in the buy zone, it is a signal to go long.
The neutral zone is the area between the upper first SD and the lower first SD. It is the area covered by the secondary Bollinger Bands. When the price is in the neutral zone, it is basically directionless, and traders should not look to place any orders in the market.
The sell zone is the area between the first lower SD and the second lower SD – it is located below the middle band. When the price is in the sell zone, it is a signal to go short.
In a trending market, traders can look to exit their trade positions when prices retrace to breach the middle band or break into the opposite zone.
For instance, in an uptrend, traders can maintain a long bias as long as prices are in the buy zone. A long position can be liquidated when prices fall below the middle band or break into the sell zone. In a strong trend, the mid-line can be used as a reference point for placing trailing stops.
Bollinger Bands Strategies in Options Trading
The fact that Bollinger Bands adjust well to volatile market conditions, makes it one of the most important technical indicators for options trading. This indicator can be used to identify periods when volatility changes as well as potential changes in an asset’s price.
In terms of volatility, Bollinger bands are able to show when volatility is reaching extreme lows, relative to the asset’s recent history. They do this by moving toward each other and ‘squeezing’ together.
Option traders refer to these low-volatility periods as consolidations. They will then place their trades in line with the new price trends that form when the asset’s price breaks out and volatility is present in the market.
A big benefit of using the Bollinger Band indicator is that it is visually very easy to identify periods when the market is more likely to break out in the near term.
The main benefits of this is that it enables options traders to control the risks present in the market, while also providing the ability to pinpoint potentially profitable trading opportunities.
Bollinger Bands squeezes and expansions imply low price volatility and high volatility respectively. This makes Bollinger Bands efficient trading indicators for volatility plays in the options market, where traders can apply long straddles and strangles when they expect high volatility in the market, or short straddles and strangles when they anticipate low volatility.
Bollinger Bands in Cryptocurrency Trading
Cryptocurrencies are an exciting new financial asset to trade online. Traders can also use Bollinger Bands as one of the indicators that can help them trade effectively in the crypto space.
This indicator still serves the same purposes as it does in other financial instruments, which is to indicate volatility in an asset’s price. As a result, traders will closely observe the contraction and expansion between the lower and upper Bollinger Bands.
Cryptocurrency traders can position themselves accordingly when Bollinger Bands squeeze in anticipation of high volatility in prices of their favourite crypto coins and tokens.
Interestingly, Bollinger Bands are able to capture about 90% of the price action in a given asset or cryptocurrency. When the asset’s price moves above or below a set Bollinger band, this means that trading opportunities are being presented.
That is, when a crypto’s price moves above the upper Bollinger band, this is an indication that the coin is overbought and is likely to correct shortly. This presents an ideal time to sell before the coin’s price will fall.
On the flip side, if a crypto’s price tags at and falls below the lower Bollinger band, this is an indication that the coin is oversold. For crypto traders, this is a sign to buy.
This approach can be used to trade a wide range of cryptocurrencies on the AvaTrade platforms, including Bitcoin, Ethereum, Litecoin, and many others.
It is important to note that the bounce or reversal strategy can also be applied to cryptocurrency trading. That is, you can prepare for a price reversal when the price approaches the upper Bollinger band in a bullish trend, or the lower Bollinger band in a bearish trend.
In many cases, it is important to understand that just because the price hits the respective Bollinger bands, this does not indicate oversold or overbought conditions.
To verify this information, this approach needs to be combined with other technical indicators that will help the trader narrow down the best possible reversal points.
Traders can develop their cryptocurrency trading strategies using Bollinger Bands, moving averages, the RSI, and oscillators. While a combination of indicators will not necessarily provide perfectly accurate reversal points, they can help to narrow down the potential reversal points.
Using Bollinger Bands with AvaTrade
Gaining knowledge of how Bollinger Bands work can really boost your trading accuracy, and hands-on experience is the best way to familiarize yourself with this indicator.
This involves opening a trading account with the multi-regulated and award winning AvaTrade and then testing Bollinger Bands and other technical indicators and tools that are available on our platforms.
To assist traders on their trading journey, AvaTrade offers access to a free demo trading account. A demo account enables a trader to test the trading platform and the available indicators and tools without the risk of losing any money. This is the ideal environment to test Bollinger Bands and how they can effectively be added to your trading strategy.
Main Bollinger Bands Trading Strategies FAQ
What are Bollinger Bands?Bollinger Bands are a technical analysis tool created by John Bollinger in the 1980s. The bands are used to gain insights into the price and volatility of a number of asset types, including currencies, stocks, and commodities. Bollinger Bands are supremely useful because they can help determine overbought/oversold levels, monitor breakouts, or be used as a trend following tool. On the chart Bollinger Bands consist of three lines. The middle line uses a simple moving average, and the upper and lower lines are placed two standard deviations away from the middle line.
How do you trade using Bollinger Bands?The first thing to understand about Bollinger Banks is that they basically show you how far price is from the average. This can be very useful information since prices tend towards the average over time. That means a price that is near the top of the Bollinger Bands channel is considered overbought, while a price near the bottom of the Bollinger Bands channel is considered oversold. When another indicator is combined with the Bollinger Bands to confirm the overbought or oversold nature of the market it becomes a simple task to trade the market.
What are the best Bollinger Bands trading strategies?A basic overbought/oversold trading strategy can work well using Bollinger Bands, but it can’t be used blindly without consideration for the overall market. So, it won’t work to just buy when price reaches the bottom of the bands or sell when it reaches the top. While this strategy can work very well during range-bound markets, it is a recipe for failure during a trending market. If the trader determines the market is range-bound then trading off the tops and bottoms of the Bollinger Bands will yield success. If the market is trending the trader should only trade in the direction of the trend if they want to be successful.
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** Disclaimer – While due research has been undertaken to compile the above content, it remains an informational and educational piece only. None of the content provided constitutes any form of investment advice.