The Secret Mindset
Bollinger Bands are a popular tool for technical analysis, consisting of three price channels representing a volatility range. The standard deviation is used to establish support and resistance levels, while the bands can act as dynamic support and resistance levels. Bollinger Bands can provide information on trend continuation, periods of consolidation, and potential price targets, but should be used in conjunction with other strategies. The width of the bands can indicate market volatility, and a squeeze strategy can be used to identify potential breakouts after periods of consolidation.
Understanding Bollinger Bands: A Comprehensive Guide
Introduction
Bollinger Bands are one of the most popular technical analysis tools used by traders to study the price movements in today’s trading environment. This article gives an in-depth insight into Bollinger Bands, their working principles, and how they can be used in trading strategies.
What are Bollinger Bands?
Bollinger Bands represent a volatility range indicated by price channels on a chart. Bollinger Bands are based on a 20-period moving average with an upper and lower band of two standard deviations above and below the simple moving average. Bollinger Bands employ a statistical measure of standard deviation to determine where bands of support or resistance levels might be located. This concept is also known as a volatility channel.
Understanding Volatility Channels
A Volatility Channel is simply a plot of lines over and below a central price level. These horizontal lines, also known as envelopes or bands, widen or contract based on market volatility. Bollinger Bands ® measure market volatility and provide useful information like:
1. Trend continuation or reversal
2. Periods of market consolidation
3. Periods of large volatility breakouts
4. Possible market tops or bottoms
5. Potential price targets
Interpreting Bollinger Bands
Bollinger Bands are a useful trend indicator because they enable traders to detect market volatility and dynamics. The bands contract when market volatility is low and expand when volatility increases. The upper band shows a statistically high or expensive level, while the lower band reflects a statistically low or cheap level. Bollinger Bandwidth correlates to market volatility.
Trading Near the Outer Bands
While trading with Bollinger Bands, it is important to understand that trading near the outer bands provides an element of confidence that there may be resistance (at upper boundary) or support (at bottom boundary). However, this concept alone does not provide relevant buy or sell signals. It only determines whether prices are high or low, on a relative basis.
Exploring the Standard Deviation of Bollinger Bands
Standard deviation is a statistical measure that expresses how much the prices of an asset differ from the mean value. Price distribution around the simple moving average is shown below:
• Around 65% of price action is contained within 1 standard deviation of the Bollinger Bands
• Around 95% of price action is contained within 2 standard deviations of the Bollinger Bands
• Almost 99% of the price action is contained within 3 standard deviations of the Bollinger Bands
Adjusting the Standard Deviation
When back-testing Bollinger Bands and adjusting its inputs, traders can change the value of the standard deviation to suit their preferences. If traders lower the standard deviation, then prices will often leave the bands, generating a lot of noise. If traders raise it to 3, prices will rarely leave the band, making it easier to find dynamic support and resistance zones.
Trading with the Odds
Successful trading involves having the odds in one’s favor. Using a standard deviation of 3.0 offers around 99% certainty that the price won’t exit the Bollinger bands, making it ideal for trading.
Using Bollinger Bands in Trading Strategies
How traders use Bollinger Bands varies depending on trading strategies, styles, and goals. For instance, some define the lower and upper bands as price targets. Others buy when the price touches the lower band and exit when the price touches the moving average in the center of the bands. The upper and lower bands can act as dynamic resistance and support levels.
Sideways Markets
In a sideways market, where there isn’t a clear trend on the chart, Bollinger Bands provide good support and resistance as it is believed that there’s a high chance of prices staying within Bollinger Bands. Studies have shown that the penetration of Bollinger Bands rarely occurs.
Trends
In a trend, it is important to trade in the direction of the main trend. When the price is making higher highs and higher lows, traders look to buy at the lower band, and when the price is making lower lows and lower highs, traders sell at the upper band. Price will be making new highs in an uptrend and new lows in a downtrend, hitting and exceeding the bands, quickly taking out the stops on trades taken directly on the bands.
Using Bollinger Bands for Squeeze Strategy
A squeeze strategy refers to the narrowing of the trading range, indicating a potential breakout. This occurs when the price starts shifting sideways in tight consolidation. The volatility of the asset usually decreases after a period of consolidation, and the lower and upper bands get closer together on the chart, indicating decreased volatility. If the price makes a larger move in either direction after a period of consolidation, it is a sign that traders are expecting that the price to move.
Conclusion
In conclusion, Bollinger Bands are an effective technical analysis tool that helps traders to study price movements in today’s trading environment. Understanding the working principles of Bollinger Bands will help traders make informed trading decisions based on market volatility, support, and resistance levels. To avoid false signals, traders should focus on price action when the price is near the edges of the bands. By using Bollinger Bands, traders can effectively understand market trends, support and resistance levels, and make effective trading decisions.
