Bollinger bands

What Are Bollinger Bands?

Bollinger Bands were developed by John Bollinger, a renowned US technical analyst. In his book, Bollinger on Bollinger Bands, he goes into depth about various ways to apply these bands. Let's break them down:

• Middle Band (Moving Average): The center line of the bands, typically a 20-period simple moving average (SMA). This helps identify the overall trend of the market.

• Upper and Lower Bands: These bands are based on the standard deviation of the price. They measure the volatility of the market. The standard deviation typically used is 2 (which means that 95% of price data is expected to lie within these bands).

Understanding the Two Main Uses of Bollinger Bands

Bollinger Bands are primarily used in two ways:

1. Trend Reversal Strategies:

   • Detect when the market may reverse direction.

2. Breakout Strategies:

   • Identify when price is breaking out of a consolidation or sideways range.

In today’s session, we’ll focus on using Bollinger Bands to identify trend reversals. I'll also mention breakout strategies briefly, but we'll explore those more in our blog posts and upcoming webinars.

Interpreting Bollinger Bands

1. The Middle Band (Moving Average)

The middle band, which is the 20-period moving average, provides us with the direction of the trend:

• Uptrend: The moving average is sloping upwards.

• Sideways Trend: The moving average is flat or moving sideways.

• Downtrend: The moving average is sloping downwards.

You can also gauge the trend based on the relationship between the price and the moving average:

• Price above the moving average = Uptrend

• Price below the moving average = Downtrend

• Price bouncing around the moving average = Sideways market

2. Upper and Lower Bands: Volatility and Trend Strength

The upper and lower bands provide us with information about the volatility and strength of a trend:

• Narrow Bands (Low Volatility): When the bands are close together, it indicates that there is little momentum or strength in the trend, typically during sideways or range-bound markets.

• Wide Bands (High Volatility): When the bands expand, it suggests that the market is experiencing increased volatility and a stronger trend.

Price interaction with the bands:

• Strong Trend: Price may "ride" along the upper or lower bands. For instance, in a strong downtrend, prices often hover near or below the lower band.

• Weak Trend: In a weak trend, price action tends to move erratically between the bands without any strong direction.

How Do We Use Bollinger Bands in Practice?

Bollinger Bands and Trend Reversals

One popular strategy involves using Bollinger Bands to identify potential W-shaped (double bottom) or M-shaped (double top) reversal patterns. These patterns signal potential changes in market direction.

Example: W-Pattern (Bullish Reversal):

Here’s how we can spot a W-shaped or bullish reversal pattern using Bollinger Bands:

1. Step 1: The market is in a strong downtrend.

2. Step 2: Price falls outside the lower Bollinger Band, indicating high volatility and a strong downtrend.

3. Step 3: A correction follows, with price moving upwards but still below the moving average.

4. Step 4: A second trough forms (similar to the first one), but this time, the price stays above the lower band, signaling weaker momentum in the downtrend.

This indicates that momentum is fading, and the market may soon reverse to the upside.

Important: The second trough doesn’t need to be perfectly aligned with the first one. As long as it’s higher than the first and stays above the lower band, we have a valid setup.

Example: M-Pattern (Bearish Reversal):

An M-shaped pattern works in reverse, signaling a bearish reversal:

1. Step 1: The market is in an uptrend.

2. Step 2: Price rises outside the upper Bollinger Band, showing high volatility.

3. Step 3: A correction occurs, where price moves downward but still remains above the moving average.

4. Step 4: A second peak forms (similar to the first), but now the price stays below the upper band, indicating weaker momentum in the uptrend.

This is a clue that the bullish momentum is weakening, and a reversal may occur soon.

Practical Considerations:

Time Frame and Sensitivity: Bollinger Bands can be adjusted to make them more or less responsive:

• Shorter Period Moving Average (e.g., 10-period): This will make the bands more responsive to market changes, picking up trend changes earlier. The downside is more false signals.

• Longer Period Moving Average (e.g., 50-period): This will make the bands less responsive, filtering out noise but potentially entering or exiting trends later.

When adjusting the sensitivity, always keep the relationship between the moving average period and standard deviation consistent. For example:

• Shorter moving averages (like a 10-period) should be paired with lower standard deviations (like 1.5) for better results.

• Longer moving averages (like a 50-period) should be paired with higher standard deviations (like 2.5).

Bollinger Bands on Market Platforms

In your trading platform (such as Market Maker), Bollinger Bands are easy to apply:

1. Select the Technicals Tab at the bottom of the chart.

2. Choose Bollinger Bands under the "Overlay" section.

3. Adjust Parameters: You can set the period (usually 20) and standard deviations (usually 2, but you can experiment with this).

4. Interpret the Bands: As we discussed, look at the price behavior in relation to the bands to understand the strength and direction of the trend. 

Key Takeaways:

• Trend Confirmation: Use the middle band to confirm the direction.

• Volatility & Trend Strength: Watch how the upper and lower bands expand and contract.

• Reversal Patterns: Look for W and M formations with price interaction outside the bands.

Conclusion

Bollinger Bands are an incredibly powerful tool for traders. By using the middle band for trend direction and the upper and lower bands to gauge volatility and strength, traders can identify potential reversals or breakouts.