Why Mastering Bollinger Bands Is A Must

Traders and investors all over the world use Bollinger bands to assess the expected price action in the financial markets. Bollinger Bands are a highly popular technical trading tool plotted at a standard deviation above and below a simple moving average of the price. It is considered the most reliable and useful trading tool since it has the best predictability in determining if the stock is oversold or overbought. I don't say this lightly, mastering Bollinger Band is a must in order to be a profitable trader.

Famous financial analyst John Bollinger developed Bollinger Bands in the early 1980s and trademarked this term in 2011. Initially, it was known as trading bands but John later evolved this concept and called it Bollinger Bands. It was designed to offer unique instincts that give investors a higher probability of determining a volatility range in which a particular security price is moving up or down.

There are three lines comprising Bollinger bands, that is, the lower, the upper Bollinger bands, and the middle. Both upper and lower bands are used in pairs in conjunction with a moving average. One of the more common calculations uses a 20-day simple moving average (SMA) for the middle band. Nonetheless, you can customize the combinations. Check out a breakdown on the image below.


Upper Lower Bollinger Band Tutorial

Bollinger Band Calculations

First, calculate a simple moving average. Next, calculate the standard deviation over the same number of periods as the simple moving average. The upper band is calculated by taking the middle band and adding twice the daily standard deviation to that amount. The lower band is calculated by taking the middle band minus two times the daily standard deviation.

Typical values used:
  • Short term: 10-day moving average, bands at 1.5 standard deviations. (1.5 times the standard dev. +/- the SMA)
  • Medium-term: 20-day moving average, bands at 2 standard deviations.
  • Long-term: 50-day moving average, bands at 2.5 standard deviations.

How To Trade Bollinger Bands 

It is important to identify oversold and overbought market conditions when using Bollinger Bands. If you touch the upper-lower Bollinger bands it is deemed as overbought and is due for a pullback. Check out the example below of Lucid Motors, where the price was severely above the Upper Bollinger Band, hinting at a pullback that followed quickly.

Lucid Motors Bollinger Band Example


On the other hand, if you go on the lower Bollinger band it is considered oversold. The prices have perhaps fallen too much and are due to bounce (but that doesn't mean they will, that is where experience comes into play!).

Note that the use of Bollinger bands varies with different traders; some traders choose to buy when prices are near the lower Bollinger bands. Most traders will exit when the price line touches the middle line. Others may buy when the price line breaks above the upper band and then sell when the price falls below the lower band.


Prices may also move really quickly in the opposite direction if you touch a Bollinger band. When the bands tighten during a period of low volatility, it increases the chances of a sharp price move in the opposite direction hence beginning a trending move this is called a Bollinger Squeeze.

There are several different ways Bollinger Bands are played, I love playing the oversold and overbought trading setups, where prices trade outside Bollinger Bands for several days (this setup takes a lot of practice and a solid trading system). Additionally, Bollinger Band Squeezes, whereas volatility comes to a standstill, it foreshadows a huge move about to take place is another useful trick (I don't play this one as much, however).

Conclusion

The beauty of Bollinger Band calculations is using the standards settings, 95% of the time price will be within the bands. The 5% of the time it is not, means often price will trade in the opposite direction soon after, as shown with the Lucid Motors example above. Being able to capture the high probability of a reversal is one of the main reasons Bollinger Bands is such a power indicator and a must for all traders.

Like everything in the market, it is not straightforward, you will definitely need to experience this indicator live, and do a ton of backtesting to get a good feel of what it is capable of. 

Check out my other articles on other indicators the ADX and RSI that can help you make money. Also, if interested in more trading systems, check out my guide to Using Ichimoku Clouds For Daytrading and The Elder Impulse System.

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