Developed by John Bollinger, Bollinger Bands define upper and lower price range levels in a chart. The bands are plotted as a standard deviation level below or above simple moving averages. The standard deviation creates distance between the bands, which adjusts when there are changes in underlying prices and volatility.
Thus, Bollinger Bands are technical indicators that help traders measure market volatility and establish when there are oversold or overbought conditions.
How the Bollinger Indicator Works
The indicator is used to identify volatility in the market. When there is low volatility, the bands tighten.
This increases the probability of sharp price movements and could be the beginning of a net trend or price direction.
When the bands have ample space between them, it indicates high volatility and signifies the end of an existing trend. The prices often bounce from one band to another, and traders can use the swings to identify profit targets. The upper band can become a profit target if the prices move from the lower band, go above the moving average, and hit the upper band.
The Bollinger Bands feature three upper, middle, and lower bands. The middle band is a 20- period moving average, whereas the upper and lower bands are two standard deviations from the moving average.
Bollinger Band Trading Strategies
Bollinger bands can enrich your analysis. You can explore several strategies to identify which one works best for you.
1. Riding the Bands
Most new traders think the best time to buy is when the prices are in the lower band and sell when they are in the higher band. That is not necessarily the case, and one of the biggest mistakes traders make is having that assumption.
When the prices touch the lower and upper band, it doesn’t mean it is a buying or selling signal. The best time to make profits is when the prices are even trending outside the bands.
By riding the bands, you give the prices time to breakouts and fly beyond the bands to make profits. The winning ratio for the strategy could be around 20% to 30%.
2. Double Bottoms
Double bottom setup is yet another trading strategy you could employ. Traders can use Bollinger Bands to identify patterns featuring “W” bottoms.
Double bottoms is identified as a bullish pattern and is characterized by two low swings, which are at around the same price level. Double bottoms occur when the instrument prices experience deep falls with considerable volume. The prices fall and close to the lower band.
Again, the prices temporarily bounce upwards, heading to the middle band and dropping lower but at a lower volume than the initial drop, closing at the lower band.
Note that the strategy is founded on the closing prices, and traders would benefit from finding the reversal patterns through this strategy. Daily closing prices have a lot of significance in trading. They help investors establish the value of an asset every day, making the double bottoms strategy ideal for daily charts.
Note that the strategy requires a lot of patience as you have to wait for a second bottom to manifest before you make any move. If you don’t mind technical analysis, the approach can work for you as it calls for the entire market analysis before you find the specific setup.
3. Trading Inside the Bollinger Bands
This is a popular Bollinger Bands trading strategy. It is suitable if you are looking to trade with minimal risk. Trading inside the bands involves trading within margins. It could be an excellent strategy for beginners or traders that are risk-averse.
4. Reversal Patterns
Trading with a reversal pattern like trading in the margins is a simple Bollinger Bands trading approach. It involves taking an opposite position when the prices move outside the bands.
Through the strategy, investors wait to monitor the performance of stocks when they move through the upper band instead of shorting during this movement.
When stocks go up dramatically and then close near their low and outside the band, it is an indicator that their value will drop from the uptrend.
Traders can decide to take short positions where there is support, which could be in the upper, middle, or lower band.
Trading on reversal patterns is an excellent strategy as it has the potential to earn you tremendous profits if you get it right. However, suppose you do it wrong; the losses can be numbing.
What Happens When Bollinger Bands Don’t Work?
You must note that just like most other things in the stock market, there are no guarantees that you will trade successfully with Bollinger Bands.
Bollinger Bands has been an effective tool for advanced traders to establish volatility; beginners may take some time before they understand and use it effectively. While Bollinger Bands can help you pinpoint spots that will give you value on the chart, you cannot use the tool to determine exactly how strong or weak the movements are.