Using Bollinger Bands to Gauge Trends

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Using Bollinger Bands to Gauge Trends

Bollinger Bands® are a sort of chart indication for technical analysis that has gained popularity among traders in a variety of markets, including stocks, futures, and currencies. The bands, invented by John Bollinger in the 1980s, provide unique insights on price and volatility. In reality, Bollinger Bands® may be used to determine overbought and oversold levels, as a trend tracking tool, and to watch for breakouts.

Key Takeaways

  • Bollinger Bands® are a trading technique used to calculate trade entry and exit points.
  • The bands are often used to identify overbought and oversold situations.
  • Trading with simply the bands is a dangerous technique since the indicator concentrates on price and volatility while disregarding a lot of other important information.
  • Bollinger Bands® are a basic trading technique that is very popular among both professional and amateur traders.

Calculation of Bollinger Bands

Bollinger Bands® are divided into three lines. For the middle band, one of the most typical formulas use a 20-day simple moving average (SMA). The top band is calculated by taking the middle band and multiplying it by twice the daily standard deviation. The bottom band is derived by subtracting the middle band from the daily standard deviation multiplied by two.

The Bollinger Band® formula consists of the following:

BOLU = MA (TP,n ) + m [TP,n ] m [ TP, n ] where: BOLU stands for UpperBollingerBand. LowerBollingerBand = BOLD MA = Moving average TP (typical price) = ( High + Low + Close ) 3 n = Number of days in smoothing period m = Numberofstandarddeviations [ TP, n ] = StandardDeviationoverlastnTPbeginnalignedperiods Text BOLU = text MA (text TP, n) + m * sigma [text TP, no] &textBOLD = textMA (textTP, n) – m * sigma [text TP, no] &textbf, where: &text BOLU = text Upper Bollinger Band &text BOLD = text Bollinger Band Lower &text MA = text Moving average &text TP (typical price) = (text High + text Low + text Close) div 3 &n = text “Number of days in smoothing period” &m = text “Number of standard deviations” [text TP, n] = text Standard Deviation across the previous n text periods of TP endaligned ​​

Overbought and Oversold Strategy

When utilizing Bollinger Bands®, one popular strategy is to detect overbought or oversold market circumstances. When the price of an asset falls below the bottom band of the Bollinger Bands®, it indicates that prices have dropped too far and are likely to rebound. When price breaks over the top band, the market is likely overbought and poised for a correction.

Using the bands as overbought/oversold indicators is based on the price’s mean reversion. Mean reversion holds that if a price deviates significantly from the mean or average, it will ultimately return to the mean price.

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Bollinger Bands® detect asset price deviations from the mean.

Mean reversion methods may be effective in range-bound markets since prices bounce between the two bands like a bouncing ball. Bollinger Bands®, on the other hand, may not always provide reliable buy and sell indications. During a strong trend, for example, the trader risks entering trades on the wrong side of the trend since the indicator may flash overbought or oversold indications too quickly.

To address this, a trader may look at the general price direction and then only pick trade signals that correspond with the trend. If the trend is down, for example, only take short bets when the upper band is tagged. The lower band may still be utilized as an exit if wanted, but opening a fresh long position would entail going against the trend.

Image by Sabrina Jiang © Investopedia2020

Create Multiple Bands for Greater Insight

“Band tags are simply that, tags, not communications,” John Bollinger said. A tag (or touch) of the upper Bollinger Band® is not a sell signal in and of itself. A lower Bollinger Band® tag is not a buy signal in and of itself. Price may and often does “walk the band.” Traders who repeatedly attempt to “sell the top” or “purchase the bottom” in such markets suffer an agonising sequence of stop-outs, or even worse, ever-increasing losses as price swings farther and further away from the initial entrance.

Using Bollinger Bands® to assess trends may be a more helpful technique to trade with them.

Bollinger Bands®, at its heart, measure variance, which is why the indicator may be quite useful in detecting trend. We may look at pricing in a whole new light by constructing two sets of Bollinger Bands®, one using the parameter of “one standard deviation” and the other using the conventional option of “two standard deviations.” This Bollinger Band® shall be referred to as “bands.”

For example, in the chart below, we can observe that anytime price remains between the upper Bollinger Bands® +1 SD and +2 SD away from mean, the trend is up; hence, that channel may be defined as the “buy zone.” Price is in the “sell zone” if it channels between Bollinger Bands® -1 SD and -2 SD. Finally, if the price oscillates between the +1 SD band and the -1 SD band, it is effectively in a neutral condition and is in unexplored terrain.

Bollinger Bands® dynamically adjust to price expansion and contraction as volatility rises and falls. As a result, the bands spontaneously broaden and shrink in response to price activity, resulting in a very accurate trending envelope.

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Image by Sabrina Jiang © Investopedia2020

A Tool for Trend Traders and Faders

After we’ve established the fundamental criteria for Bollinger Band® “bands,” we’ll show how this technical tool may be employed by both trend traders looking to capitalize on momentum and fade traders looking to benefit from trend exhaustion or reversals. Returning to the aforementioned chart, we can see how trend traders would position themselves long after the price reached the “buy zone.” They’d be able to continue in the trade since the Bollinger Band® “bands” would capture the majority of the price movement of the move upward.

The answer varies depending on the trader, but one plausible approach would be to cancel a long trade if the candle on the candlestick charts turned red and more than 75% of its body was below the “buy zone.” Using the 75% criteria, pricing certainly breaks out of trend at that moment, so why insist on a red candle? The second requirement exists to prevent trend traders from getting “wiggled out” of a trend by a rapid move to the downside that snaps back to the “buy zone” at the conclusion of the trading session.

In the chart below, notice how the trader is able to continue with the move for the most of the uptrend, quitting just as price begins to consolidate at the top of the new range.

Image by Sabrina Jiang © Investopedia2020

Bollinger Band® “bands” may also be a useful tool for traders who want to profit from trend fatigue by assisting in identifying the price turn. However, counter-trend trading necessitates far higher margins of error, since trends often make numerous attempts at continuance before reversing.

The chart below shows how a fade-trader employing Bollinger Band® “bands” might detect the earliest signs of trend weakening. After prices have fallen out of the trend channel, the fader may elect to employ Bollinger Bands® in the traditional way by shorting the next tag of the upper Bollinger Band®.

In terms of stop-loss levels, setting the stop close above the swing high almost guarantees the trader is stopped out, since the price will often make numerous incursions at the recent topasbuyers tryto prolong the trend. Instead, measure the breadth of the “no man’s land” section (the gap between +1 and -1 SD) and add it to the top band. By utilizing market volatility to assist determine a stop-loss level, the trader avoids being stopped out and is allowed to stay in the short trade until the price begins to fall.

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Image by Sabrina Jiang © Investopedia2020

Bollinger Bands Squeeze Strategy

A squeeze approach is another method for using Bollinger Bands®. A squeeze happens when the market has moved strongly and then begins to move laterally in a tight consolidation.

When the price of an asset is consolidating, the upper and lower bands get closer together, allowing a trader to visually detect it. This indicates that the asset’s volatility has diminished. Following a period of consolidation, the price often makes a greater move in either direction, preferably on heavy volume. Expanding volume on a breakthrough indicates that traders are voting with their money that the price will continue to move in the direction of the breakout.

The trader buys or sells the item when the price breaks through the upper or lower range. Traditionally, a stop-loss order is placed outside the consolidation on the other side of the breakout.

Image by Sabrina Jiang © Investopedia2020

Bollinger vs. Keltner

Bollinger Bands® and Keltner Channels are two distinct but related indicators. Here’s a quick rundown of the differences so you can determine which one you prefer.

Bollinger Bands® employ the underlying asset’s standard deviation, while Keltner Channels use the average true range (ATR), which is a measure of volatility based on the security’s trading range. The interpretation of these indications is typically the same, regardless of how the bands/channels are produced.

One technical indication is not superior to another; it is a personal preference depending on whatever works best for the techniques being used.

Because Keltner Channels employ average true range rather than standard deviation, more buy and sell signals are created than when using Bollinger Bands®.

The Bottom Line

Bollinger Bands® may be used for a variety of purposes, including overbought and oversold trading indications. Traders may also use numerous bands to show the intensity of price movements. Looking for volatility contractions is another method to utilize the bands. These contractions are usually followed by major price breakouts, preferably on high volume. Bollinger Bands® are not the same as KeltnerChannels. While the two indications are comparable, they are not identical.

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