How to profit from Bollinger Bands
Developed in the 1980s by John Bollinger, this oscillator is a technical indicator that incorporates the idea that volatility is dynamic, so the bands adapt as volatility increases and decreases. The tool uses a moving average with volatility bands placed above and below it. This provides the trader with a relative definition of high and low.
What Are Bollinger Bands?
Bollinger Bands can be used to identify W-Bottoms and M-Tops and help determine the strength of a trend. They can also help traders easily recognize highs and lows and can be used to find overbought and oversold areas. Since they are dynamic, they can be used on different securities with the standard settings.
Bollinger Bands are made up of a set of three bands that are plotted in relation to the security’s price action. The middle band is typically a simple moving average set at 20 periods. The outer bands are normally set two standard deviations above and below the middle band. If the price action becomes more volatile, the bands will widen. If volatility decreases, the bands will contract and move closer to the average.
W-Bottoms And M-Tops
Arthur Merrill, author of Behaviors of Prices on Wall Street, identified 16 classic chart patterns with a basic W shape and 16 classic chart patterns with a basic M shape. Bollinger Bands can be used to help spot these patterns. If the Bollinger Bands confirm a W-Bottom or M-Top, it could signify a potential breakout and possible trend reversal.
Overbought And Oversold
According to Bollinger, the bands should contain a majority of the price action, which means that a move outside of the bands should be considered significant. Generally, as the prices move closer to or break through the upper band, the market could be considered overbought and as the prices move down to or break through the lower band, the market could be considered oversold.
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Indicators: Bollinger Bands ®
newdigital, 2013.08.06 13:51
How Bollinger Bands Indicator Works
Bollinger Bands calculations uses standard deviation to plot the bands, the default value used is 2.
Calculation
The middle line is a simple moving average
The upper line is: Middle line + Standard Deviation
The lower line is: Middle line - Standard Deviation
Bollinger considered the best default for his
indicator to be 20 periods moving average and the the bands are then
overlaid on the price action.
Standard Deviation is a statistics concept. It
originates from the notion of normal distribution. One standard
deviation away from the mean either plus or minus, will enclose 67.5 %
of all price action movement. Two standard deviations away from the mean either plus or minus, will enclose 95 % of all price action movement.
This is why the Bollinger Bands indicator uses the standard deviation of 2 which will enclose 95 % of all price action.
Only 5 % of price action will be outside the bands, this is why
traders open or close trades when price hits one of the outer Bands.
The Bollinger Bands indicator main function is to
measure volatility. What the Bollinger Bands upper and lower limits try
to do is to confine price action of up to 95 percent of the possible
closing prices
This indicator compares the current closing
price with the moving average of the closing price. The difference
between them is the volatility of the current price compared to the
moving average. The volatility will increase or decrease the standard
deviation.
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Indicators: Bollinger Bands ®
newdigital, 2013.08.06 13:54
Bollinger Bands and Volatility
When volatility is high; prices close far away from
the moving average, the Bands width increases to accommodate more
possible price action movement that can fall within 95% of the mean.
Bollinger bands will widen as volatility widens. This
will show as bulges around the price. When bollinger bands widen like
this it is a continuation pattern and price will continue moving in this
direction. This is normally a continuation signal.
The example below illustrates the Bollinger bulge.
High Volatility and Low Volatility
When volatility is low; prices close closer towards
the moving average, the width decreases to reduce the possible price
action movement that can fall within 95% of the mean.
When volatility is low price will start to
consolidate waiting for price to breakout. When the bollinger bands is
moving sideways it is best to stay on the sidelines and not to place any
trades.
The example is shown below when the bands narrowed.
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Indicators: Bollinger Bands ®
newdigital, 2013.08.06 13:57
Bollinger Bands Indicator Bulge and Squeeze Technical Analysis
The Bollinger Bands are self adjusting which means the bands widen and narrow depending on volatility.
Standard Deviation is the statistical measure of the
volatility used to calculate the widening or narrowing of the bands.
Standard deviation will be higher when prices are changing
significantly and lower when markets are calmer.
When volatility is high the Bands widen.
When volatility is low the Bands narrows.
The Bollinger Squeeze
Narrowing of Bands is a sign of consolidation and is known as the Bollinger band squeeze.
When the Bollinger Bands display narrow standard
deviation it is usually a time of consolidation, and it is a signal that
there will be a price breakout and it shows people are adjusting their
positions for a new move. Also, the longer the prices stay within the
narrow bands the greater the chance of a breakou
The Bollinger Bulge
The widening of Bands is a sign of a breakout and is known as the Bulge.
Bollinger Bands that are far apart can serve as a
signal that a trend reversal is approaching. In the example below, the
bands get very wide as a result of high volatility on the down swing.
The trend reverses as prices reach an extreme level according to
statistics and the theory of normal distribution. The "bulge" predicts
the change to downtrend.
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Indicators: Bollinger Bands ®
newdigital, 2013.08.06 14:04
Bollinger Bands Trend Reversals- Double Tops and Double Bottoms
A Forex trader should wait for the price to turn in
the opposite direction after touching one of the bands before
considering that a reversal is happening.
Even better one should see the price cross over the moving average.
Double Bottoms Trend Reversals
A double bottom is a buy setup/signal. It occurs
when price action penetrates the lower bollinger band then rebounds
forming the first low. then after a while another low is formed, and
this time it is above the lower band.
The second low must not be lower than the first one
and it important is that the second low does not touch or penetrate the
lower band. This bullish Forex trading setup is confirmed when the
price action moves and closes above the middle band (simple moving
average).
Double Tops Trend Reversals
A double top is a sell setup/signal. It occurs when
price action penetrates the upper bollinger band then rebounds down
forming the first high. then after a while another high is formed, and
this time it is below the upper band.
The second high must not be higher than the first
one and it important is that the second high does not touch or penetrate
the upper band. This bearish Forex trading setup is confirmed when the
price action moves and closes below the middle band (simple moving
average).