Five Secrets Bollinger Bands Reveal
February 11, 2014, Tuesday, 05:51 GMT | 00:51 EST | 11:21 IST | 13:51 SGT
We have been blessed with Bollinger Bands since John Bollinger created them in the 1980s. Now, many a trader uses Bollinger bands in a variety of ways, each seeking their way to vast fortunes.
For the chartists amongst us, a Bollinger band on a chart adds perspective and context to price movements that otherwise may look quite random.
What are Bollinger Bands?
Bollinger bands are usually set up with a 20 period simple moving average and an upper and lower band that’s displaced by 2 standard deviations from the central moving average using the same 20 periods.
Within the beauty of the bands, several secrets can be revealed.
1. Spotting the Runaway Trend
The area between the upper and lower bands set at two standard deviations contain 95.45% of the price. When price reaches the extreme outskirts of the channel it may be tempting to assume that price will retreat back inside, letting you get on board a reversal trade. After all 95.45% encapsulates almost everything.
It’s important to note that Bollinger bands capture 95.45% of past price. The future may forge out its own new territory.
Don’t be fooled into thinking that price will ricochet back into the band where it belongs! Very strong trends can run like a freight train above the channel or below the channel. These can be some of the best trends because they run up or down with almost no time for pullbacks.
Learn to recognize the freight train move and capitalize.
2. Gauging Momentum
Have you noticed that when price really takes off, the outer Bollinger Band on the opposite side of the trend direction can move away from the trending price?
When the opposite outer Bollinger band moves away like it’s running from a plague it’s a sure sign of a strong trend.
When the opposite outer Bollinger band turns back to move in the direction of the trend, that’s when the trend is losing momentum. That may be a place where you’ve caught the best of the move and it’s time to move on. Or will you hold on and wait for the trend to resume?
3. Banging on Opposite Extremes
Some financial products go from one outer Bollinger band to the other and then back again. It’s often accompanied by a flattish middle Bollinger band. When we see this it’s a good indication that the financial product’s in a range, not a trend.
Where this occurs, it makes sense to trade a return inside the Bollinger bands or to assume support or resistance may hold.
4. Spotting a Reliable Trend
Strong and stable trends tend to stay on one side of the middle line, pulling the central moving average in the trend direction.
If we put on another Bollinger band at 1 standard deviation, while keeping the 2 deviations Bollinger band, we can see how tidily the trend falls in the outer channel between 1 and 2 standard deviations.
If price has been travelling quite nicely along the channel that’s created, it may provide a structured channel to put together a structured risk-reward trade for an opportunity to profit.
5. Identifying the Market State
Sometimes price moves smoothly and other times it’s wilder.
Trading systems often suit one or more of the four market states, but usually not all of them. The market states are trending volatile, trending quiet, ranging volatile and ranging quiet.
Bollinger bands can help you identify which market state you’re in. Here’s how:
Signs of volatility:
The outer bands are wide apart.
The outer bands are increasing their distance between them.
Signs of quiet:
The bands are narrow.
The outer bands are contracting their distance between them.
Signs of trends:
The middle Bollinger band slopes towards the trend direction.
Price tends to stay on one side of the Bollinger band or trades outside of it in a particularly strong trend.
Signs of ranges:
The middle Bollinger band is horizontal or close to it.
Price travels repeatedly from one outer Bollinger band to the opposite and vice versa.
Putting it all together we can make an assessment of the current market state and compare it with the conditions that our trading system(s) perform best.
We want to have a higher frequency of trading in conditions that our trading.
Bollinger Bands For Profit
Bollinger bands make up a helpful part of a traders toolkit, giving clues about the market and where it may be heading next.