Investing in the financial markets is an exciting yet challenging roller coaster ride. Traders have to do research, study in detail, analyse the market and accordingly select their trading procedure.
The process helps traders make plans and strategies that would operate as an indicator or signal in investing.
There are a massive number of strategies that support particular markets or instruments of trade. Traders can use it individually or combined for profitable trading.
The article will put light on an old and most frequently used indicator, the Bollinger Bands. One of the indicators of the financial market helping traders achieve high trade performance.
Bollinger Bands is a trading indicator that was introduced several years ago by John Bollinger. It guides traders to know their market entry and exit, potential overbought and oversold situations, and know the market volatility to have a managed trade.
So, let’s jump in readers to the Bollinger Bands trading strategy world for using it accurately and earning profits.
What is Bollinger Bands Trading Technique?
The price envelope strategy was introduced in the market by John Bollinger in the 1980s. Bollinger found it as a statistical instrument represented on charts, which help identify the price and volatility of the financial instruments.
The strategy uses a formula to calculate the market factors impacting. So, the investors use it as a tool that uses methodical tools for an informed decision.
Bollinger Bands strategy is a technical analysis tool provided by online brokers like ABInvesting. Traders can employ the indicator by using the trading platform provided by the broker, here MetaTrader4.
The trading platform has various tools and indicators that notify the traders when a change occurs and could guide for a better trade. Read our ABInvesting Review.
The Bollinger Bands indicator is displayed on the graphical charts by lines (three) that are referred to as the bands. It consists of N periods which are the moving averages, K times is the upper band, and the lower band is also visualised by K times.
The upper band with N period is the standard deviation above the moving average. In contrast, the K times or lower band with N period is the standard deviation below the moving average.
There is the middle band which is the middle line of the three bands. It is significant for traders to analyse the market trend. Middle band is less used in the analysis process but holds the same significance as the other two bands.
With these lines or bands (upper and lower), traders make their assumptions about the market movements and when they can enter or exit the market.
In addition, traders can use these in different timeframes, primarily N and K for 20 and 2 days, respectively.
Traders can employ the moving average or any other type of average that suits their trading instrument.
However, in the default choice, it’s always the moving average. Investors can use the Exponential moving average due to their high usability after moving average.
The Bollinger Bands was registered as a U.S trademark in 2011 from Bollinger’s word.
The trading strategy is a significant analysis tool as it assists traders in defining the high and lows of the price of the market instrument.
If we understand it simply, when the prices are high of the instrument traded, it shows the upper band, and when the prices are low, it shows the lower band.
Thus, traders can recognise the patterns formed on charts and accordingly make their decisions. Although for this, traders require market understanding along with the trading strategy.
If used properly, traders can achieve their goals and make high profits from their trades.
How to use Bollinger Bands Indicator?
By now, readers are aware that Bollinger Bands is a technical trading strategy that analyses the prices of the instrument to identify the overbought and oversold conditions.
But, the query that arises is how do we use the trading strategy?
With the paragraph, readers will get an answer to this question. The technical tool makes traders aware of the market, whether the market is silent or loud. This gives an idea of the action that traders have to take next.
For example, say the market is silent, then traders will assume that the bands are contracting. Similarly, when the bands are loud, it is assumed that the bands are expanding.
To benefit from the trading strategy, traders need to study the price movements and how Bollinger Bands work. When the price of the instrument is quiet, the bands get close, and when the price is loud, or they move upwards, the bands are spreading.
Reading the chart is vital for the strategy to work, and therefore knowing what sign indicates what market changes are necessary.
The upper and lower bands of the trading strategy measure the volatility of instruments for a specific period of time. The bands keep moving or adjusting with the market changes and display the same on charts.
Hence, the position of the three lines or bands is important for the traders, as they can analyse the market positions of the instrument and decide their next action for getting good market returns.
The Bollinger Bands strategy has created its use in the market over time and is preferred by traders of all financial markets. Thus, understanding it will aid traders in smooth trading.
Whenever the prices move up or low, they tend to move back to the middle position or the middle of the bands. The prices keep bouncing when they go up; they will gradually come in the middle and then down. That’s why it is said that Bollinger Bands bounce back to the middle.
For example, suppose the last position of the bands was up or on the top so, it is predicted that the band will next move down. This is called the Bollinger Bounce, which is created due to the nature of Bollinger Bands.
They act as the dynamic support and resistance levels.
When the trader is in a longer time frame, they will have strong bands. Traders use the bouncing factor in the trade when they are trading in a range, and there’s no significant trend in the market. They identify the width of the bands and check the trends for the use of the approach.
In the market situation when the bands are expanding, traders should usually avoid using Bollinger Bounce as this indicates that prices are not moving in range and there is a trend followed.
Traders should look for band contraction or stability for using the Bollinger bounce approach for the trade.
Bollinger Bands Behavioral Patterns
The behaviour of the Bollinger Bands strategy is essential before knowing it further. The strategy has two behavioural patterns: the squeeze and the breakout.
So, here are the two patterns explained for smooth use of the strategy. First, we’ll be looking into the Bollinger squeeze and, next, the Bollinger breakout.
Bollinger Band Squeeze
The Bollinger band squeeze is a self-explanatory term that means when the bands squeeze or get close together. When the bands squeeze, it indicates that a breakout is about to happen.
In such a situation, the bands are to be studied carefully. If the chart showing the bands has candles coming out of the top band, then it is considered that the move will continue upwards.
When the candles breakout from the below or lower Bollinger band, then the price will move downwards. The investors have to simply look at the bands on the charts and the position of candles to make an assumption.
Hence, knowing the position of the bands and candles is necessary for the correct decision. So, that is how the Bollinger squeeze works for market trading.
The situations usually occur in a week, and traders, therefore, should monitor the charts regularly in a 15-minute chart.
The charts show various situations of the bands sometimes moving up or sometimes down. By studying these charts, the investors make their decision; however, traders should take time and make accurate decisions as the patterns may have a squeeze or breakout situation as well.
Mostly, traders go for a sell when they see the price hitting the upper band; they assume a sell signal which may be wrong because of the breakouts and squeeze taking place.
Thus, traders should check as they may be right or wrong in such market conditions.
To identify the condition, traders can combine the trading strategy with other indicators.
Next, they can base their judgement on the price action of the instrument. The price action is essential as they are the analysis guide. Moreover, traders can check with the support and resistance levels and make their decisions.
In the squeeze situation, the Bollinger Bands suggest through the large volatility thus major price changes taking place in the future.
After this, there is a narrow squeeze that signals the breakout taking place. This is an effective point for the trade as Bollinger Bands play an important role in this.
Therefore, traders should watch the charts in intervals and regularly to get the exact picture of the bands and market situation for the trade.
Calculating the Bollinger Bands
Bollinger Bands strategy, we know, is provided by the online brokers, and they are indicated on the charts for making a trade decision.
In the trading platforms, the calculations of the Bollinger Bands are done automatically by the softwares. But, for proper analysis, investors should be aware of the manual process of calculating the Bollinger Bands.
Here is the calculation process explained for easy trading with the indicator. Bollinger Bands include the below-given formulas:
- Calculation of 20 period simple moving average
- Calculation of SD
- Using the standard deviation (SD) for measuring the upper and lower bands
The first thing to calculate is the standard deviation; for this, traders check the X bar.
The formula for calculating the x bar is simple and is similar to the simple moving average. Therefore,
X bar = SUM/N
Here, the x bar is the SMA value.
SUM is the value of periods used; say, if the investor uses 20 periods, the trader will add 20 values.
N is the number of periods as per the above case here; 20 will be the N.
In short, traders add all the 20 values and then divide them by the time period to know the x bar.
SD is calculated with the following formula:
S = √Σ (X-Xbar)2/ N-1
Here, S is the standard deviation
Σ is sigma which indicates the summation
X is the number of equals of the sum
X bar is the standard value or the SMA
N is the number of the time period
If we take the following formula with the data of 20, 22, 25 prices with the period of three days SMA is 22; the SD will be:
The sum is equals (20+22+25) 67
So, the bar is equal to 67/3, which gives 22.3
SD is equal to 12.67 which is derived by (20-22.3) ^2 + (22-22.3)^2 + (25-22.3)^2
This further gives 5.29 + 0.09 + 7.29 = 12.67
In the end, the 12.67 is divided by the N-1, which is 2 as we take the three days’ prices.
The result is 6.33, and when we square root, it will give 2.516
In this way, traders can get the SD; moreover, the traders can know the upper and lower bands.
Why use the Bollinger Bands Strategy?
Bollinger Bands strategy is a useful trading tool of analysis. This guides the traders to know the market changes and instrument investment timings. Below are the points that make the strategy worth using in the price analysis:
Readers will definitely agree with this point of user-friendly as the Bollinger Bands is an easy to understand strategy. Traders can study the charts, know the market positions of the instrument and invest.
Moreover, it is easy to measure the standard deviation and know the overbought and oversold situations.
The bands in charts give an idea of the price of the instrument, making it simple and efficient for use.
Confirm the trends
With the Bollinger Bands, traders can know the market trends for the squeeze and breakout situation are studied, and that works in range only.
In addition, the strategy is efficient, effective, used globally, and adjustable for the traders to understand and make their investment profitable.
Bollinger Bands strategy is a highly recommended and traditional trading technique to analyse the price of the traded instrument.
Traders with the article can understand the trading strategy and combine it with others for a more confident trade. It is user-friendly, adjustable, and helps in achieving the desired goals.
The upper bollinger band, middle band and other aspects are discussed for proper use of the strategy.
However, traders should first check it with the market and trade instruments for efficient use.