What are Bollinger Bands?
Bollinger Bands (BB) were developed by the technical analyst John Bollinger as a volatility indicator. They consist of two Bands, drawn below and above a simple moving average (SMA) of any market. Bollinger Bands were designed to show a trader when a large move might be expected. The bands are drawn around a SMA with a standard deviation, which is a mathematical formula that measures price volatility, giving a visual representation of how the price might vary from its current value.
Calculations for Bollinger Bands:
- an N-period moving average (MA)
- an upper band at K times an N-period standard deviation above the moving average (MA + Kσ)
- a lower band at K times an N-period standard deviation below the moving average (MA − Kσ)
Typical values for N and K are 20 and 2, respectively.
If the formula above seems complicated don’t worry too much; what is important is to understand the rationale behind it. As the two bands are dependent on the underlying instrument’s volatility, it follows that the bands automatically narrow when volatility is low, and widen when volatility increases. Please see the pictures below to better illustrate John Bollinger’s ideas.
What Do You Get to Know When Using Bollinger Bands?
The following images provide an overview of how to read Bollinger Bands. The first image will be used to explain how to use Bollinger Bands and what the lines represent. The second set of images provides a quick breakdown of what a Bollinger Band in trading means with regards to trends, volatility, and breakouts.
How to Read a Bollinger Band in Trading
The image above shows a Bollinger Band plotted on a price chart for the Forex pair EUR/USD. As you can see, two purple lines flow in line with the Forex pair’s price movements over time. The part in between these two lines is shaded purple to show the width of the band and, in turn, how the candlesticks are rising and falling.
The final line you’ll see on the chart runs through the middle of the bands and candlesticks. This red line is the 20-day Simple Moving Average (SMA). An SMA is the average price of an asset over a specific time. The SMA is calculated by taking the average closing prices. When you’re using Bollinger Bands in trading, the SMA is typically calculated over a 20-day period.
So, what you get when you add a Bollinger Band to a price chart is the following elements:
- Two bands above and below the asset’s daily price fluctuations
- Daily price movements
- A 20-day SMA line to show the average price
When you combine these three elements, you can see how the price of an asset is moving. In the image above, the price of EUR/USD moves slightly up before hitting a downward trajectory. The Bollinger Band shows you how the price is moving on a relative basis, i.e. how high are the highs and how low are the lows relative to the moving average.
From this, you can start to determine whether the market is overbought (price moving towards the lower band) or oversold (moving closer to the higher band). Bollinger bands also give you an indication of how volatile the market is.
The images below show various stages of volatility and how you can build this information into a Bollinger Bands strategy:
Diagram A
When the bands are contracting it indicates that we can expect major price movements.
Diagram B
When the bands are far apart and the price breaks through these, and then comes back within the bands, that should indicate that the current trend is ending.
Diagram C
If the price moves outside the bands, we can expect a continuation of the current trend.
Diagram D
If the price touches one of the bands, it follows that the price will reach the other band at some point too.
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Interpretation of Bollinger Bands
When you know how to read Bollinger Bands, you’ll see that they show major price movements and also give a sign of whether prices are relatively too high or too low. The images shown in the previous section help demonstrate this. However, it’s important to remember that the function of Bollinger Band analysis isn’t to signal when it’s correct to buy or sell.
You can use Bollinger Band in trading to get a better idea of when to make moves. What it’s advisable, however, is to use Bollinger Bands in isolation. We suggest combining a Bollinger Bands strategy with other indicators to help determine the expected direction of price movements and identify tops and bottoms.
Some of the indicators you may choose to use in conjunction with Bollinger Bands are:
- Relative Strength Index (RSI): This is a momentum indicator that’s displayed on a line graph as an oscillator. This means it’s shown as a value between 0 and 100. A calculation is used to show the speed and significance of recent price changes. From this, you can determine whether the asset is potentially over or undervalued.
- Moving Average Convergence Divergence (MACD): This oscillating indicator shows the relationship between two moving averages. The averages are compared to see whether they’re diverging (moving away from each other) or converging (moving towards each other). A diverging average can indicate that momentum is increasing. A converging average suggests momentum is decreasing.
- Parabolic SAR: This indicator is used to establish the direction an asset’s price is moving. It’s marked on a price chart using dots and the aim is to give traders potentially profitable entry and exit points by indicating whether the market is bullish or bearish. A dot below the price suggests the market is bullish, i.e. performing better than expected. A dot above the price suggests the market is bearish, i.e. performing worse than expected.
Bollinger Bands and Risk Management
The function of Bollinger Band indicators is to show the relative price performance of an asset and, in turn, the market’s volatility. You can use this information as part of a wider risk management strategy. Essentially, you can use automated buy and sell orders, as well as take-profit and stop-loss limits, based on the information gleaned from Bollinger Bands. To learn more about this, click here to read our risk management trading guide.
Setting up Bollinger Bands in your Skilling platform
- Period: The default set-up is 20, referring to the number of periods. You can change this as you see fit.
- Deviations: Usually the standard deviation multiplier is set at two. Again, this can be tweaked to your preference.
- Price inputs: The most commonly used price is the ‘Close’, but you can apply the ‘Open’, ‘Low’ and ‘High’ to determine the calculations.
Skilling Summary
Bollinger Bands are very widely used by technical analysts and may be another indicator to make our top ten of important trader tools! Although the formula to work them out may appear daunting (which you don’t need to learn to use) the application of them is straightforward and logical. The premise is that markets go through periods of calm (low volatility) and excitement (high volatility). We think all traders should, at least be familiar, with Bollinger Bands!
More Resources
Enhance your knowledge of trading and refine your Bollinger Bands strategy with these resources:
- To learn about CFD trading strategies, such as risk management, click here.
- To learn more about leverage, click here.
