Understanding Bollinger Bands
Bollinger Bands is one of the most famous indicators out there, developed by a technical analyst named John Bollinger in the 1980s. This indicator primarily identifies the volatility level of a currency pair. Bollinger bands are volatility bands placed below and above a moving average. These bands are designed such that they automatically widen when the market volatility increases and narrow or contract when volatility drops.
One of the important purposes of the Bollinger bands is to determine the relative high and low prices of the market. As simple as it gets, the prices are comprehended to be low at the lower band and high at the higher band. With this definition, we can come up with trading patterns that can help predict the upcoming market trend.
Calculation
Bollinger bands have three bands, namely, the upper band, the middle(mean) band, the lower band. And they are calculated as follows:
Upper Band = Middle band + 20-day Standard deviation x 2
Middle Band = 20-period the moving average (20 SMA)
Lower Band = Middle band – 20-day Standard deviation x 2
Below is a chart that has the Bollinger Bands embedded in it.
Setting up the Bollinger band
Every trading platform will ask you for the length of the Bollinger band. By default, the value is set to 20. And it is highly recommended to keep the default configurations to obtain optimal results from the indicator.
Now, let’s put all of the above information into action by analyzing some great strategies.
Strategy 1: Double Bottom Setup
One of the most popular trading strategies using the Bollinger bands is the double bottom setup. This is because John Bollinger himself said that, “Bollinger bands can be used in pattern recognition to define pure price patterns such as “W” bottoms, “M” tops, momentum, shifts, etc.”.
In this strategy, we will be discussing the “W” bottoms, and “M” tops.
W-Bottoms
This strategy can be applied when the market is coming from a predominant downtrend. There are four stages to consider to trade the W-bottom (double bottom) Bollinger band strategy.
- The reaction low must form around the lower band.
- From the lower band, there must be a bounce up to the middle band.
- Thirdly, there should be a new low, which must hold above the lower band. The hold above the previous low confirms the inability of the sellers to push the prices lower.
- Lastly, the price must move off the low and break the previous resistance. This confirms the start of bullishness in the market.
Example
In the below chart, the market was in a downtrend. It made a low at the lower band and went up until the middle band and held. This satisfies the first two considerations in the W-bottom strategy. Moving forward, the price comes down again, but this time, it holds above the lower band. This confirms the third consideration, as well. Finally, the market shoots up and breaks the resistance (black line), indicating a buy signal.
M-top
M-top is the opposite of the W-bottom strategy. But, the working of this strategy remains the same. That is, firstly, the price must try to go above the upper band. Secondly, the price should drop down to the middle band. Thirdly, it must go up again but not higher than the previous high. And finally, the market must drop below the support line. And once all these scenarios take place, we can prepare to go short.
Example
In the below chart, the market went above the upper band, pulled back to the middle band, shot up again, but could not go higher than the upper band, and finally, the price dropped below the support (black line). So, this is when we can confidently hit the sell.
Strategy 2: Return to the Mean or Middle of the band
If you wish to extract only small profits from the market, then this strategy will be apt for you. This strategy mainly focusses only on small movements rather than big swings. An advantage of this strategy is that you will be able to pull off consistent profits and reduce risks significantly.
The principle of this strategy is to go long when the price comes down to the middle line. However, to reduce the risk, there are some factors which are implemented when trading this strategy. Below, we have mentioned some of the techniques to trade this strategy.
In the below chart, we can see that the market shot to the upside, pulled back to the middle line, and again shot up north. Here, if we were buying at the middle line, we would have made a profit out of it. But, not always will this work in your favor.
There are some points you must consider before trading this strategy. Firstly, the initial buyers must be very strong. Secondly, the sellers (pullback) must be weaker than the preceding buyers. Thirdly, the price must hold around the mean line. The occurrence of patterns like doji, hammer, spinning top, etc. around the mean line can give additional confirmation on the trade. Therefore, once all the criteria are satisfied, you can go for the buy.
Bottom line
Bollinger band is an excellent indicator to determine the direction of the market. The bands indicate if the market is at a relatively high or low. And these highs and lows help in predicting if the market is continuing its trend or preparing to reverse. Also, chartists combine this indicator with other indicators to have an extra edge over their trade.
We hope you understood these strategies. It is highly recommended to try these in your daily trading activities. With practice, you can master this indicator and can make consistent profits if used correctly. Let u know if you have any questions in the comments below. Happy Trading!