Bollinger Bands Trading Strategy Explained

Suppose you are searching for a helpful way to decide the entry and exit points while trading, the bollinger bands serve you best. Thanks to Mr. John Bollinger, we have this handy tool. Bollinger bands are an excessively popular indicator that precisely points out the over-sold and over-bought trading areas. Hence, it tells about the volatility of an asset. 
Bollinger bands can be applied in all financial markets. The bollinger bands can be used for intraday trading. It is an adaptive trading band that can be used in all time frames with a very- short-term periods, which include months, hours, or weekly periods.

What are Bollinger Bands Exactly?

One can use the bands on almost all financial instruments such as commodities, equities, foreign exchange indices, bonds, and futures & options. It is quite an effective tool put to use by investors and traders for investing and short term or mid term mid-term The standard deviation is a key aspect in bollinger bands which gives the amount of variation of a data from the mean value.

The bollinger bands are a kind of statistical chart that comprises price channels or bands plotted on the chart. They are a price envelope in the upper and lower price ranges. There are three bands used for the calculations. The Centre line or the middle band is generally a simple moving average. The upper and lower bands are the standard deviations of security. The bands keep on expanding and contracting with the price of a security.

A Stock can be trading for an extended period in a trend. During that period, it will have some volatility concerning the different points in time. To get a clear understanding of the trend, traders filter the price action using a moving average. This helps collect crucial information regarding the trading patterns of the market. For example, following a rise or sliding down in a trend, the market will likely achieve some stability. The trading will narrowly take place and go above and below the moving average in a zig-zag manner. 

Traders will look to observe this kind of behavior using the price bands describing the trading activity pattern as the markets behave precariously on any given day even while they trade in an uptrend or a downtrend. The moving averages with support and resistance lines assist in anticipating the changes in stock prices. The input parameters chosen determine how the chart summarises the data. This gives a buy its response based on the magnitude and frequency of price variations.

First, traders draw the upper resistance and lower support lines. Using these, they try to estimate and form the channels within which they hope the prices to remain. Some traders connect either the top or bottom of the prices to identify upper and lower extremes. Then they add parallel lines to identify the channel where the prices may move. 

Until the prices do not go out of the channel, the trader remains assured that price movements are stable. If the stock prices continuously reach the upper band, it indicates that prices are overbought. Opposite to this, a man says the prices are oversold when the stock prices touch the lower band. 

How this Bollinger Bands Indicator Works

The phenomenon in which the bands come closer indicates a period of low volatility. It increases the chances of steep price movement, either rising high or falling down. This may lead to the beginning of trending moves. One should be aware of any false move in opposite directions, which can reverse before a significant trend begins. In case the bands separate in a large amount, it shows that volatility is increasing, and the continuing trend may end soon. 

The prices tend to jump between the band’s envelope into and from motions, moving from one band to the other. One can use these swings to mark the potential profit targets. For instance, a price touches the lower band and subsequently crosses above the moving average. In that case, the upper band is the profit target. 

Further, an asset’s price can go beyond the band envelope for long durations or stick to it. This happens in periods of strong trends. If the price moves away from the bands with many fluctuations, one should consider researching before looking for more profits. If the price moves beyond the bands, it is an indication that a strong trend will continue. At times the prices may again move immediately between the bands. This suggests that the strength of the trend declined.

How to Calculate the Bollinger Bands

The bollinger bands consist of three lines, and you must consider it for the best bollinger bands strategy. To find the middle band, calculate the average price of a security over specific time periods. The upper band takes the center band and two standard deviations. The lower band takes the middle band but subtracts the two standard deviations. To find the standard deviation take the square root of the variance, which is the average of squared differences of the mean. The following is the bollinger band formula.

BOLU=MA(TP,n)+m∗σ[TP,n]
BOLD=MA(TP,n)−m∗σ[TP,n]
where;
i) BOLU=Upper Bollinger Band
ii) BOLD=Lower Bollinger Band
iii) MA=Moving average
iv) TP (typical price)=(High+Low+Close)÷3
v) n=Number of days in smoothing period 
vi) m=Number of standard deviations
vii) σ[TP,n]=Standard Deviation over last n periods of TP
You can use this formula to find the upper and lower bands.

What Does this Bollinger Bands Indicator Suggest?

The bollinger bands indicator is a unique tool heavily used. Most traders believe that the closer the prices shift towards the upper band, the more overbought the market is. In the same way, if the prices are moving closer to the lower band, the market is more oversold. This tool’s inventor set 22 rules to follow while using the bands as a trading system. Standard deviation is a measure of volatility. The gap between the bands enlarges in volatile market conditions and contracts in low volatile situations. One will have the following results using the bollinger bands. 

Squeeze

It is the name of the phenomenon where the bands come close. This hints at a period of less volatility. Traders consider it a potential sign of increasing volatility in the future, providing trading opportunities. On the other hand, if the bands move away from each other, it is a sign of high volatility. So the traders consider exiting their trades. We should note that these are not trading signals though. The bands do not indicate the time changes will take place or the direction in which the prices will move. 

Breakouts

9 out of 10 times, the price action remains between the two bands. A breakout is a significant event where the price goes above or below the bands. Breakout is not a trading signal, but people make mistakes believing it as is. The breakouts give no hint regarding the direction and the magnitude of price variations in the future. 

What is the Day Trading Uptrends with the Bollinger Bands

The bollinger bands indicator shows how much an asset rises and when it loses its strength. A strong uptrend can make the price touch the upper band more often. Indicates that the traders can use the opportunity and buy that asset. The prices may fall back within the uptrends, lie above the middle band, and then go back to the upper band. This is an indication of good strength. Typically, prices in the uptrend don’t reach the lower band. 

In case they do so, it is a signal of reducing the asset’s strength. Traders generally gain profits from strong uptrends before any reversals. If a stock doesn’t reach a new peak, traders usually sell the asset to avoid losses. They keep an eye on the behavior of uptrends to know when it gets stronger. They consider it a sign of an upcoming trend reversal. Most traders aim to make a profit from the strong uptrends before the trend changes its direction. If the stock falls to reach its highest pick, then the trader sells the stock in order to avoid any losses from the reversal trend.  Technical traders monitor the behavior of this uptrend and observe for indication of a possible reversal trend to prevent any losses.

Day trading downtrends with Bollinger Bands strategy.

Bollinger band strategy can also be used to determine how strong a financial asset is falling and indicate when it’s potentially reversing to an upside trend. In a strong downtrend, the price of assets will run along with the lower band, and fortunately, the price will be run along with the lower band, which will show the intense selling activity. But if the price falls to the lower band, then the downtrend will lose momentum. 

In downtrends, price pullbacks or highs should stay below the middle band and move toward the lower band. It indicates the asset has a lot of downtrends. In a downtrend, the prices must not break the upper band of the bollinger bands as it shows that the trend can do the reversing. Most traders avoid the downtrend method. The duration of a downtrend with the bollinger band strategy is short or long; it can be either minutes, hours, or even weeks, months, or years. A trader needs to identify the downtrend. If the lower band shows a steady downtrend, then the trader must be cautious and try to avoid any long trades as it will cause the trader more chance of their loss.

Identifying the W-bottoms and M-tops.

Bollinger band uses the W pattern to identify when the second low in the chart is lower than the first down but does hold the lower band. The W- Bottoms and M-tops are a part of Arthur Merill’s work identifying 16 patterns with basic W and M patterns. In the W-Bottoms, the price pulls back toward the middle or higher, creating a place for the lower band. And when the price moves, the high of the first pullback the W-bottom form in the chart.

An M-top occurs in the price chart when a reaction moves close to or above the upper band. The price pulls back in the middle band and then creates a new price high but does not go above the upper band of the Bollinger band. The price shows the M shape in the chart.

Conclusion

Bollinger bands are a highly effective tool for technical analysis. They are one of the best indicators to analyze volatility and trend strength. This is very extremely important while opening and closing trades in volatile markets. They are also helpful in estimating the trend reversal. Bolinger bands base themselves on historical information and thus respond to price movements but do not consider upcoming price movements. One should consider risk management controls while implementing the bollinger bands trading strategy. 

A Bollinger band is a helpful tool for technical traders, but still, it has some lagging quality. However, the trader uses this strategy to identify trends, not the price.  The Bollinger band either tells about the uptrend or the downtrend of the asset. This is because this strategy uses the simple moving average and takes the average prices of several price bars. The bollinger band developer suggests that a trader can use a system along with two or three non-correlated tools to provide a more direct market signal of any financial assets.

Frequently Asked Questions (FAQs)