What Are Bollinger Bands?

Table of contents:

Using Bollinger Bands

Pair with Other Indicators

FAQs

If you are an active trader or a novice trader, then you have definitely heard about such an indicator as Bollinger Bands. Not all traders will use it, but everyone should take a look. Bollinger Bands allow you to estimate the current price of an asset and its volatility. Bollinger Bands consist of three bands on the chart: the middle band is the moving average, above and below the standard deviation band. By assessing the price relative to the Bollinger Bands, you can determine whether the price of an asset is currently high or low. Key takeaways:

• Bollinger Bands consist of a middle band (simple moving average), and upper and lower bands.
• Bollinger Bands allow you to estimate the price and volatility of an asset.
• Bollinger Bands can help identify lows in a double bottom pattern.
• Bollinger Bands can help identify highs in a classic M top pattern.
• Bollinger Bands help determine the highs in the Three Pushes to High pattern and their amplitude.
• Bollinger Bands show the fading of a trend or its active phase. Bollinger Bands can help you determine your stop loss and entry point into a position.
• Bollinger Bands cannot replace a full-fledged trading strategy; they can only serve as an addition to such a strategy.

Using Bollinger Bands

It is very important to note that when the price approaches the lower band or the upper band, which are typically set at a certain number of standard deviation units from the moving average, it does not serve as a signal to buy or sell. When you trade in Forex for example, and when making a decision to buy or sell, you cannot rely on only one indicator. Bollinger Bands, like any other indicator, will not provide you with a complete trading strategy. This is because the strategy consists of many factors that need to be taken into account, and a full analysis of the chart must be carried out.

The price may move beyond the Bollinger Bands, for example during a pronounced uptrend or downtrend. This means that if the price reaches the upper limit or breaks through it, this does not necessarily serve as a signal to sell, since this may be the beginning of an uptrend, and by selling the asset after breaking the upper band, your trade may reach a stop loss in this case.

John Bollinger, a financial analyst and trader, developed Bollinger Bands in the 1980s as a tool to measure market volatility. Initially called "volatility bands," these bands were designed to adapt to changing market conditions. John Bollinger's innovative approach was to use standard deviation to calculate the width of the bands, allowing them to widen when volatility increases and contract when volatility decreases. This dynamic feature has made Bollinger Bands a popular tool among traders and investors for analyzing price action and potential trading opportunities. When the price moves outside the bands, it can serve as a warning sign for potential trend reversals or overbought/oversold conditions.

Bollinger Bands can be a great addition to your trading strategy: you can combine it with other indicators, like Simple Moving Average. In conjunction with Bollinger Bands, you can use trading patterns such as the Double Bottom, the Classic M Top, or the Three Pull High. Let's talk about these chart patterns in more detail:

Double Bottom

Bollinger Bands, which are based on standard deviation, can be used in conjunction with the double bottom chart pattern.

It is believed that a “double bottom” serves as a good signal to buy. Here’s what happens on the chart: the price moves down, forming a minimum that can break through the lower band, moves up from that minimum, and returns to the same minimum again (approximately near the lower band). Having touched the same level twice, the price reverses and a bullish trend begins.

IMPORTANT: When using any trading model, before entering a trade you need to wait for the level to be retested. This means that if, for example, you see a “double bottom”, you do not need to enter a trade immediately after you see that two lows have formed. Instead, wait until the first low is formed in a bullish trend (a trend always forms lows and highs); then, after the first low the price goes up again, it makes sense to enter the trade. This increases the likelihood that a bullish trend is starting.

What are the Bollinger Bands showing us at this moment?

Without Bollinger Bands, the stock might appear to be moving down toward a second low, especially if the second low is lower than the first low. But with the Bollinger Band, a second low could indicate that the stock is preparing for an uptrend.

The Classic M Top

The classic M Top pattern is the same as a double bottom, only in reverse. The price forms a double high, and then a bearish trend begins. The price first approaches the upper band or breaks through it, then rolls back down; the second time, it approaches approximately the same high. The fact that the second high is within the upper end of the range suggests that it is a relative lower high. For many traders, this second high signals a sell. But just like with a double bottom, you need to wait for the first high in a bearish trend to form before entering a position.

Three Pushes to High

The "three pushes to high" pattern is a technical analysis signal that can often precede a bearish trend reversal in a financial market. This pattern gets its name from the sequence of successive higher highs that are formed, with each high exhibiting certain characteristics in relation to the Bollinger Bands indicator.

To constitute a valid "three pushes to high" pattern, three distinct higher highs must shape up on the price chart. The first high is typically an extremely strong bullish move that carries the price beyond the upper band. This first high represents an overextended move to the upside, with the asset becoming overbought as buyers bid it up aggressively.

The second high in the pattern does not surpass the previous high but still manages to touch or get very close to the upper band level. This shows that while buyers still have some conviction, their momentum is waning compared to the first push higher.

Finally, the third high is formed, but this time the price fails to reach the upper band, instead turning lower from somewhere within the band's range. This diminishing upside momentum signals that the bullish uptrend is losing steam.

After this ebb and flow of buying pressure across the three pushes higher, the asset's price will often reverse down from the third high in a decisive bearish trend. The Bollinger Bands help quantify just how overextended each price action was, with the first being the most extreme from normal volatility.

Another tell-tale sign that a "three pushes to high" pattern may lead to a downturn is contracting trading volume as the third high is being formed. This highlights further erosion of buying interest even as prices continue higher for that last price action.

Overall, the "three pushes to high" pattern represents a loss of upside conviction by buyers and can serve as an early warning of an impending bearish trend reversal in many markets.

Signaling the Starts or the Ends of Trends

Bollinger Bands, which use standard deviation to measure volatility, can also indicate the end of a trend. Typically, a pronounced trend begins after breaking through a certain trading range. The more aggressively prices move up or down (with a larger pullback at the highs or lows), the larger the range from the upper Bollinger Band to the lower band will be. The upper band and lower band will seem to “expand”, and the moving average (middle band) will have a lot of curves. When the bands narrow back, this may mean that the trend is temporarily fading, or may even turn in the opposite direction.

Another interesting application of Bollinger Bands, which use standard deviations, is based on the observation that volatility tends to revert to its mean: periods of low volatility tend to be followed by high volatility, and vice versa.

Narrow bands indicate compression, which means low volatility. But remember that as volatility reverts to its mean, the bands are likely to widen, signaling a possible sharp move. A simple way to determine compression is to determine when the bands are narrowest over the past six months.

If you want to enter a long position based on a squeeze, then try to look for an entry point behind the upper Bollinger Band. In this case, the stop loss can be placed at the border or slightly beyond the border of the upper Bollinger Band. If you want to open a short position, then look at the entry point below the lower band, and you can place a stop loss on the upper band or slightly above the upper band. Again, when you are looking to enter a bearish or bullish trend, it always requires at least one that has formed high or low in the direction of the trend you want to enter in order to define this trend. Thus, you do not need to enter a position immediately as soon as the price breaks out of the Bollinger Bands; instead, wait until one low or high is formed, and then, when you have reliable reasons to believe that a trend has begun, you can enter.

When trading in this way, it is very important to also take into account other indicators and factors, such as levels. Bollinger Bands will not always give you a reliable entry point or the correct stop loss, so you should always rely on several factors. Let Bollinger Bands and standard deviations be an addition to your strategy, not the basis.

Pair with Other Indicators

Given that Bollinger Bands operate as a pristine reflection of price movements, an intriguing strategy emerges when intertwining them with volume indicators, thereby delving deeper into market dynamics. It's important to acknowledge that no single indicator possesses the omnipotent ability to unfailingly pinpoint market bottoms or peaks. Nevertheless, combining Bollinger Bands and standard deviations with supplementary tools like chart pattern recognition systems paves the way for a more nuanced approach to trading, empowering traders to cultivate sharper insights and execute more informed decisions in the ever-evolving financial landscape.

FAQs

What are the cons of Bollinger Bands?

Bollinger Bands are useful but have limitations:

• False signals (they can give false signals, especially in times of low volatility)
• Lagging indicators (they rely on historical data and may lag behind market changes)
• Over-reliance (using them alone without confirmation can be risky)
• Market conditions (they work best in trending markets, but are less effective in sideways markets)
• Subjectivity (interpretation can vary among traders)
• Lack of predictive power (they don't predict future prices moves accurately)

Consider these factors when using Bollinger Bands for trading decisions.

What is the best Bollinger Band strategy?

There isn't a one-size-fits-all "best" Bollinger Band strategy, as effectiveness can vary based on market conditions and individual trading styles. However, there are several strategies in which you can use Bollinger Bands: the double bottom, the classic M top, or three pushes to high, signaling the starts or ends of trends.

How accurate is the Bollinger Band?

Bollinger Bands are a popular technical analysis tool, but like any indicator, they are not always 100% accurate. Upper and lower bands’ effectiveness can vary depending on market conditions, asset volatility, and the specific trading strategy being used.