What are Bollinger Bands ?
Bollinger Bands are one of the most popular volatility indicators developed by John Bollinger.
Visually depicted by three bands, the Bollinger Bands is a useful indicator to identify periods of low volatility, marked by contraction in the bands and periods of high volatility marked by expansion of the bands.
Bollinger Bands indicator is a useful tool for identifying potential breakouts in prices and also serves to act as a dynamic support and resistance indicator and can be used to shows trends as well. Here’s your detailed guide to understanding Bollinger Bands.
Anatomy of Bollinger Bands
Bollinger Bands are made up of three lines or bands that are continuously plotted on the price chart. The lines, known as the outer, lower and middle Bands are primarily based on a 20 period simple moving average.
This is known as the middle Bollinger Band. The upper and lower or outer bands track the 20 period SMA with 2 standard deviations. The 20, 2 Bollinger Band setting is a default configuration for the Bollinger Bands.
When applied to the daily chart, the 20, 2 Bollinger Band configuration aims to track the volatility of prices for the past month.
The first chart below shows the 20, 2 Bollinger Band indicator applied to the daily chart.
The Bands indicator can be used on any time frame and any market, including Forex or even stocks.
Bollinger Bands – Contraction & Expansion of Volatility
The most notable feature of the Bollinger Bands indicator is the contractions and expansions of the bands, which depict rising and falling volatility. Volatility in the markets is the degree of variation in prices over time measured by the standard deviation of returns.
When volatility falls and prices move in a tight price range, it signals an imminent breakout or expansion of the bands. The longer the prices are in a contraction, the stronger the expected volatility breakout.
The chart above illustrates the Bollinger Bands contraction and expansion. The rectangle area shows prices moving in a tight sideways range with no trend being established just as yet.
This sideways range is indicated by the Bands which are also contracting. Following the contraction, the Bollinger Bands then expand as both the upper and lower bands deviate in opposite direction, depicting the increased volatility.
As you can see, the Bollinger Bands indicator is a great tool to have when gauging potential breakout periods. For trend traders, this can be especially useful as the Bollinger Band indicator can be used to not only trading the breakouts but also shows when a trend is stronger based on the volatility of prices.
Bollinger Bands – Walking the Bands
Another common way of using the Bands indicator is known as walking the bands. In this scenario, when a trend is strong, prices tend to hug the upper or lower Bollinger Bands also known as walking the bands. When prices exhibit this phenomenon, it is understood that the trend is quite strong. Occasionally, prices may revert back to the 20 period moving average line, but remains above the middle Bollinger Band.
The chart below shows a near perfect example of trends and walking the bands. Starting from the left side of the chart, prices steadily trading within the 20 period moving average and the upper Bollinger Band line with frequent tests to the upside, indicating an uptrend in prices.
After a considerable period of the strong uptrend, prices then start to move sideways within a range, confirmed by the Bollinger Band contraction and highlighted by the rectangle.
This contraction period is indicative that prices could see a volatile breakout. Eventually, as the volatility increases, Bollinger Bands expand with prices now moving lower and hugging the lower Bollinger Band line, or walking the band in the downtrend.
As illustrated below, we can see that Bands can be used not just for volatility but also to depict the trends in prices.
Bollinger Bands – Dynamic Support and Resistance
Another common use of the Bollinger Bands indicator is the ability to act as dynamic support and resistance levels. The next chart shows how the upper and lower Bands act as dynamic support and resistance levels and how prices react to these levels in the future.
On the very left side of the chart, notice how a previous support level identified near the lower Bollinger Band then acts as a support just before prices break strongly higher.
Similarly once prices move up, there are many different resistance levels that are formed. The first resistance level exhibits price behavior as the resistance is broken which then turns to support and then eventually back to resistance, while new resistance levels are formed towards the right side of the chart.
Bollinger Bands – An All-in-One Indicator
The Bollinger Bands indicator is truly versatile as it helps in identifying trends, showing when volatility is likely to rise and where potential support and resistance levels are formed.
Trading with Bands indicator can be a great way to avoid having to use multiple indicators and thus keeping the chart analysis simple.
When combined with other oscillators that are momentum based, you are more likely to have a full picture of the prices that are forming and thus be able to trade better.