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What are Bollinger Bands?

Bollinger Bands, a technical indicator, can help traders identify overbought and oversold conditions and spot potential breakouts.

COVER Bollinger

Bollinger Bands® are a type of chart indicator named after their creator, John Bollinger, who took the idea of plotting moving averages one step further. He used the concept of standard deviation to define the upper and lower boundaries of a price move as against the average price of an asset (or forex pair) for any given time frame.

In appearance, Bollinger Bands resemble a diaphanous stocking enveloping the moving candles on a chart and forming a sort of snake-like channel. There’s a thin line in the middle of the Bollinger Band. This line, by default, is equal to the 20-simple moving average (SMA). Candles above this line would be considered bullish, whereas candles below the line would be bearish.

Settings for Bollinger Bands

You’ll find Bollinger Bands under indicators on any chart on your OANDA trading platform. Once you’ve selected the Bollinger Band, it will wrap itself around the candles. You can select standard deviation values for Bollinger Bands in the settings area. The higher the value of the standard deviation, the wider the band and therefore, more of the price action the band will contain.

Once you have added the indicator to your chart, you can adjust the deviation settings by opening the indicator settings. A window will open showing you the default setting of 2. If you raise this value to the upper values of 2 or even 3, the indicator will capture more of the price movement within the Bollinger band. You can also change the default 20 length to, say, 50, should you prefer to work with this value instead.

  • For a value of 1, 65% of price action is contained with the Bollinger Band
  • For a value of 2, around 95% of price action is contained
  • A standard deviation setting of 3 contains almost 99% of price action in a Bollinger Band

Remember, lower settings will generate more signals, but will also increase the number of false signals, as the candles will more often push through the upper and lower lines of the Bollinger Band.

How to trade using Bollinger Bands

Because Bollinger Bands typically contain most of the instrument’s price movement, price will usually but not always keep within the Band. In the example below you’ll notice that once price touches the top of the band, it reaches a zone of overbought territory and starts to revert to the midline moving average. If the trend is strong it may bounce off the midline moving average and resume its upward climb, but generally price will cut through the middle and fall until it lands on the bottom of the band and a zone that is potentially oversold territory. From here, except in a downward trend, it is very likely to climb back up.

For a trader, these tops and bottoms of price movement within a Bollinger Band can serve as entry and exit points. When it comes to using Bollinger Bands on strong trends, you will have better trading results selling the tops of Bollinger Bands on a downward trend, while refraining from trading the dips around the bottom of the bands. You should then apply the opposite approach for an upward trend.

In a ranging market, the upper and lower bands can act as reliable areas of support and resistance. What you must never forget is that the boundaries to these bands can be stretched to accommodate an injection of volatility, either to the upside or downside.

For instance, even when candles can be seen pressing up against the top of a Bollinger Band, this doesn’t automatically give you a sell signal. This is because, if volatility is strong enough, buyers can push the bands still higher. The same applies to a downward move. In a strong trend or trend reversal, the candles will puncture the sides of the bands, forcing the bands to stretch even further.

To avoid getting caught out by volatility, it is good practice to wait for some sign of confirmation that price is returning to the direction you want to trade in. So, for example, if you’ve concluded the trend is up and you wanted to go long, rather than entering a trade as the most recent candle prints against the bottom outer line of the band, wait until you see bullish candles taking price up again before placing your order.

Importance of timeframes in Bollinger Bands

It is easy to forget that every Bollinger Band reflects price movement within a different time frame. The screenshots below show the EUR/USD pair for a day and for 4 hours over the same time period.

In the first chart, the daily, there is some bullish action near the base of the band and plenty of room above it. So you might think to go long. However, on the four-hour chart, price is nearing the top of the band and, as the overall picture since the middle of May has been bearish for the euro, a short may in fact be a better choice.

So, in cases like this it might be more prudent to look for other means of identifying which is the better trade, long or short. You could, for instance, look at what the dollar is doing against other pairs. Or you could look at other indicators, such as volume, MACD and moving averages. As with most trading decisions, it always pays to finalise your analysis with reference to more than one indicator.

Bollinger Bands squeeze strategy

Traders who are wary of relying too heavily on indicators will often make an exception when it comes to checking for a squeeze in a Bollinger Band. When price enters a period of consolidation and low volatility, the Bollinger Band starts to tighten around the narrowing range of candles. This squeeze of the band signals a high probability that price is about to break out, usually with high volume.

When the breakout occurs, price will usually move in the direction of the breakout for some considerable time. Some squeezes can last days or even weeks. As you can see from the screenshot below, there was a squeeze in the Bollinger band for about six weeks before price broke out to higher levels during November of 2020.

To identify a potential breakout, look at the hooks of the outer and lower Bollinger Bands. If the bands remain flat, or one band hooks but the other stays flat, the breakout isn’t there yet. But if you see both upper and lower bands opening up, you know that volatility is rising and a breakout could be about to occur.

Key takeaways

  • The Bollinger Bands indicator uses the concept of standard deviation to define the upper and lower boundaries of a price move as against the average price of an asset (or forex pair) for any given time frame.
  • Bollinger Bands give a more faithful reading of changes in price in a ranging market. In a trending market, volatility can suddenly stretch the bands wider causing trading signals to fail.
  • Bollinger Bands can give a different picture for price action according to the timeframe, so it’s important you check various timeframes to establish direction and best points for entry and exit before placing a trade.
  • When the Bands squeeze tightly around the candlesticks on your chart, limiting their range, it is highly probable this period of consolidation will be followed by a strong breakout, either to the upside or the downside.

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