Bollinger bands are one of the most powerful technical indicators available. They are sometimes referred to as a trading envelope. The neat thing is, Bollinger bands work in any global market, including equities, futures, options, and Forex.
With this in mind, here’s a quick overview of how to trade using Bollinger bands.
What are Bollinger Bands?
Bollinger Bands, developed by John Bollinger, are essentially lines that are plotted at a specific interval around a moving average. They can be used for determining the trend strength as well as volatility.
There are three bands in a Bollinger band – upper band, middle band, and lower band. The figure below depicts the three bands.
The first outer band (upper band) is formed by adding two standard deviations to the moving average. The middle band is actually the simple moving average, usually for a period of 20 days.
The second outer band (lower band) is formed by subtracting two standard deviations from the moving average.
The overall width of the bands indicates volatility – wider the band, more the volatility; more narrow the band, lesser the volatility. Whenever the price is stable, the bands are seen to be in a narrow range.
Uses of Bollinger Bands
There are many uses of Bollinger bands.
#1 Identifying Overbought and oversold levels
Bollinger Bands are used by traders for identifying oversold as well as overbought zones.
- The market is said to be overbought whenever the prices move towards the upper band.
- Whenever prices move nearer to the lower band, the market is said to become oversold.
Whenever the prices enter the overbought and oversold levels, there is a high possibility of price reversal.
#2 For Buy and sell signals
Bollinger Bands can also be used for identifying buy and sell signals.
- Sell signal is triggered when a candle is formed above the upper band which is then followed immediately by a candle that is below the upper band.
- Buy signal is generated when a candle is formed below the lower band and is immediately followed by another candle above lower band.
This is best illustrated using the chart below. Here, you can clearly see the buy and sell signals generated using Bollinger bands. The green arrow shows a buy signal, and the price is seen to trend upwards. The red arrow shows a sell signal, and the price immediately falls downwards.
#3 For Identifying Breakout / Breakdown in Stocks
Bollinger Bands can be used for identifying the upcoming breakout or breakdown of stocks. Before any significant price advance or decline happens, the Bollinger Band Squeeze occurs. Whenever the volatility falls to low levels and the Bollinger Bands narrow, it is called as a Bollinger Squeeze.
Since periods of low volatility often precedes periods of high volatility, Bollinger Squeeze is usually a good indication that a big up-move or down-move is about to happen.
The figure below shows a Bollinger squeeze after which the stock surged ahead.
#4 For Confirming Divergences
Bollinger bands, when used in conjunction with other indicators, can be used for confirming divergences. For example, when the price reaches the upper band, but other indicators (like RSI or ROC) does not support the upward move, a divergence is generated. This, in turn, would indicate a sell signal.
Summary
Bollinger Bands is a highly useful technical analysis tool. Its middle band (SMA) dictates an overall direction for the security while its outer bands indicate the level of volatility. The bands are wider whenever the price is volatile, and are narrower whenever the price is stable. Bollinger bands can be used to identify Buy/ Sell signals, overbought/oversold levels, divergences, and upcoming breakout/breakdown in the stock prices.
Happy Trading!
Tara
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