What Are Bollinger Bands?

Bollinger Bands are an effective and common technical analysis indicator that is used by traders in order to understand the price volatility of a specific financial instrument.

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

Bollinger Bands are used for trade analysis. Based on how the indicator is performing, we are able to extract information on the direction and strength of a price trend. We can then use this information in order to confirm trade signals from other indicators or strategies.

The secret to trading, using any technical indicator, is to understand its behaviour in different conditions. For example, the asset price is said to be in the overbought zone when it touches the upper Bollinger Band. Similarly, the price is in the oversold zone when it touches the lower Bollinger Band.  Overbought and oversold conditions have a higher likelihood of price reversal.

Traders who prefer to trade on strong bullish trending markets should look for a situation where the price moves between the 20-day moving average and the upper Bollinger Band. Consequently, a steady downward trend is characterized by price movements between the lower Bollinger band and the 20-day moving average.

There are other characteristics that traders can look out for when using Bollinger Bands. For example, they can watch out for ‘the Squeeze,’ which is a situation where the Bollinger Bands seem to converge or come together.

A squeeze (the bands contracting) is an indication that the price is experiencing low volatility. Low volatility periods will always be succeeded with high volatility.

When high volatility returns to the market, the upper band will rise, while the lower band will fall. If the price breaches the upper band, it will imply a bullish breakout, whereas a bearish breakout will be spotted when prices breach the lower band. As a rule of thumb, the longer the squeeze, the stronger the expected breakout.

Traders should also avoid being misled by breakouts, which are usually situations where the price moves past either the lower or upper Bollinger Bands.

Unfortunately, this is not often an accurate or reliable indication that the price will behave in a certain way. Price volatility alone is not enough to help make decisions that can help traders to achieve success in trading.

This means that using Bollinger Bands alone is not a reliable approach to market analysis. As a result of this, traders need to consider using this indicator in conjunction with other technical indicators.

Combining Bollinger Bands with other indicators can help traders to make better-informed decisions regarding their trades. The best combinations with Bollinger Bands are oscillators such as the RSI and MACD.

Bollinger Bands are great at pinpointing value price areas in the market, but they do not show the price strength or weakness at such areas. This is where oscillators come in. In addition to evaluating overbought and oversold conditions, oscillators also provide much information using divergences.

For instance, if the price is trading near the upper band of Bollinger Bands, but the RSI is showing a bearish divergence (price rising but indicator value falling), it is a signal for price weakness and traders can place sell orders in the market.

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.


Using Bollinger Bands with Friedberg Direct

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 Canadian-regulated Friedberg Direct and then testing Bollinger Bands and other technical indicators and tools that are available on our platforms.

Another major benefit is that Friedberg Direct provides you with direct access to trade a wide choice of assets including forex, stocks, indices, and many more.

To assist traders on their trading journey, Friedberg Direct 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.

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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.