What Are Bollinger Bands?
Bollinger bands are, in simple terms, trendlines that can help you identify when an asset may be oversold or overbought. To put it another way, Bollinger Bands are a technical analysis tool that provide a way for you to see which assets may be undervalued or overvalued and where the price may move.
This type of technical analysis was developed and copyrighted by John Bollinger. His style of analysis involves looking at two standard deviations (positive and negative) away from a simple moving average (SMA) price. This analysis results in three lines (i.e. Bollinger Bands) that offer insights into an asset’s price and volatility.
A Bollinger Bands chart is comprised of three lines:
The upper line = This is the positive price trend. The value/point at which this line appears on a chart is calculated by adding twice the standard deviation to the SMA.
The middle line = This is the SMA. The SMA is the average closing price of an asset over a particular timeframe. As a standard, the SMA is generated over a 20-day period.
The lower line = This is the negative price trend. The value/point at which this line appears on a chart is calculated by subtracting twice the standard deviation from the SMA.
Pivot Points vs. Bollinger Bands
Pivot points are another technical analysis tool used by traders. These markers are used to track reversals in the price of an asset i.e. when it pivots from a bullish trend to a bearish trend and vice versa. Pivot points are calculated by finding the average price from the day’s high and low points, as well as the previous day’s closing price.
It’s possible to use Bollinger Bands and pivot points to inform your decisions. As a general rule, Bollinger Bands give you an idea of where the market is heading. Pivot points give you an overview of the market in the present. Therefore, when it comes to pivot points vs. Bollinger Bands, it’s a case of using the former to look at the present and the latter to look into the future.
The History of Bollinger Bands
Bollinger Bands were created in the early 1980s by John Bollinger. He saw the need for an adaptive technical trading tool that could account for the dynamic nature of volatility. Prior to Bollinger’s innovation, the popular belief was the volatility was static.
Bollinger Bands dispelled this idea and are now applied to a variety of financial instruments, including forex, commodities, equities and futures. The bands can be used for multiple timeframes i.e. hours, days or months. The main question you’re aiming to answer when you analyse Bollinger Bands is: are prices high or low in relative terms compared to the average?
How Do Bollinger Bands Work?
Bollinger Bands allow you to see whether the price is too high or too low during a given period. Moreover, they allow you to assess the volatility of an asset over time. To explain how this works in practice, here’s how to calculate Bollinger Bands.
- The first thing you need to establish is the SMA. This is done by establishing the average price of an asset based on its high, low and closing prices for a given time period.
- From this, you can calculate the standard deviation. This means how spread out the numbers are from the average value. In this instance, you’re looking for the standard deviation of the various price points used to obtain the SMA. In other words, you’re looking at how much each individual price point varies from the average.
- Next, you need to calculate the square root of the variance (i.e. the average of the squared differences of the mean/average) to get the standard deviation.
- Once you have this figure, you can multiply it by two. This is the important number. It’s important because you can add it to the SMA to create an upper band or subtract it from the SMA to get the lower band. You can do this at any point along the SMA line in order to chart the upper and lower variance during that time period.
Should You Use Bollinger Bands?
Bollinger bands can be a great way to analyse prices and trends. However, they’re not a complete solution. You should consider them as one tool within a toolbox of ways to consider the relative value of financial instruments. The positive and negatives below should help you decide whether this is the right way for you to analyse the markets.
The Advantages of Using Bollinger Bands
- Bollinger Bands give you an insight into the relative price of an asset vs. its average price. This, in turn, allows you to chart its volatility and, therefore, predict how the price will change over time.
- The squeeze is when the upper and low bands move close together for a period of time. This is regarded as a point of low volatility and sign that, potentially, more volatility is on the way.
- The breakout is when the price of an asset exceeds the upper or lower band. In general, 90% of an asset’s price activity occurs within the upper and low bands. However, there will be times when it rises above or drops below these bands. This allows you to notice major events that may have an impact on the asset.
The Risks of Using Bollinger Bands
- Bollinger Bands can be used in isolation but this isn’t recommended. John Bollinger himself recommends using this type of technical analysis alongside other non-correlated indicators that provide direct market signals. Other tools you can use are the relative strength index (RSI) and moving average convergence divergence (MACD).
- Squeeze and breakout points aren’t indicators. Although Bollinger Bands can highlight potentially useful shifts in the volatility of an asset, they can’t be taken as indicators in their own right. For example, a breakout signals a move beyond an upper or lower band but it doesn’t mean the price has reached a point where you should buy or sell. It’s simply highlights a change in dynamics that can be used in conjunction with other data.
Why Do Traders Use Bollinger Bands As a Strategy?
The main reason for using Bollinger Bands as a trading strategy is to ascertain when it’s best to enter or exit a position. The best way to do this is to look for breakout points when the price drops below or rises above the lower and upper bands.
The price dropping below the lower band can indicate that the asset has been oversold. In other words, the price has fallen too much and could be due to increase in value. Conversely, an asset could be overbought if its price rises above the upper band. This means the price is too high and it could be due to drop.
This type of analysis is particularly important in forex trading because prices fluctuate significantly on a daily basis. Indeed, of all the financial instruments you can trade, forex can be the most volatile. Because Bollinger Bands are designed to analyse volatility, they’re a useful way to determine when you should execute buy or sell positions and, moreover, when you should start and stop trades.
How to Use Bollinger Bands As Part of Your Trading Strategy?
You can start using this technical analysis tool by completing the steps below:
- Read our online broker reviews to find a suitable trading platform.
- Create an account and make a deposit.
- Select your desired market. Bollinger Bands work well in forex but can also be used for a variety of financial instruments.
- Find an asset within the market you’ve chosen and use the tools option inside the trading platform.
- Select a time period and apply Bollinger Bands to your asset.
- Review the data and start a trade.
Use Bollinger Bands As Part of an Overall Trading Strategy
Bollinger Bands are a great way to assess the volatility of an asset. They can’t give you all the information you need and they shouldn’t be used in isolation. However, if you want to know where the price of an asset might be going, this is a great technical tool.
The best way to trade is to use a variety of strategies. From technical analysis to news updates, financial reports and expert insights, your job is to analyse as many data points as possible. Bollinger Bands can help you build up an overall picture of an asset but they won’t provide all the answers. Therefore, you need to use all the tools offered by our recommended online trading sites to give yourself the best chance of making a profit.