Bollinger Bands is a technical study that helps the trader visualise where is the current price in relation to a mean price consensus for the period. As a secondary insight, Bollinger bands are a good indicator of the volatility of the market.
The Bollinger Bands Study was created by a technical analyst and options trader named John Bollinger. It is an indicator which is usually plotted on a candlestick chart. Bollinger Bands consists of three bands which lie on the price chart, unlike the other indicators which are drawn isolated from the price chart (candlestick chart).
The three bands consist of an upper band, a lower band, and the Simple Moving Average mean line. These bands are also referred to as envelopes. It determines the relative high and low prices of a market.
The prices are said to be relatively high at or beyond the upper band and relatively low at or below the lower band. The use of the standard deviation to assess this information is that on a Normal (Bell) Shaped Distribution, 68% od the prices lie within ±1 standard deviation and 85% od the prices within ±2 standard deviation.
This information helps in pattern recognition. If, for instance, we identify a bearish reversal pattern and the price is at or beyond +2SD the odds that this pattern materializes in a reversal or retracement is much higher than if this happens elsewhere near the centre of the channel.
Other useful information the Bollinger Bands provide is the possibility of a trend continuation and phase of market consolidation.
Calculation of Bollinger Bands
As we said, the Bollinger Bands are composed of three bands, which is the upper band, lower band, and a middle band, which is a Simple Moving Average. To compute it, the first step is to determine the Simple Moving Average (SMA) of the security’s closing price. The SMA is usually calculated for 20 number of periods. So, a 20-period SMA of the closing price for the most recent 20 days is plotted. Next, the standard deviation (SD) of the same period is calculated. SD is a term mainly used in statistics, finance, and economics and is measured by taking the square root of the variance (average of the squared differences of the mean).
Now, this SD is multiplied by a number m. The standard Bollinger band uses 2 SD, but, as John Bollinger says in his book on Bollinger Bands, the trader can add different bands, such as ± 1 and ±3 SDs. The obtained values are added with the SMA, which yields the Upper Bollinger Band. Similarly, the difference between the SMA and the SD gives the Lower Bollinger Band.
The Formula is given as follows,
UBB = SMA [Close, n] + m * σ[Close, n]
LBB = SMA [Close, n] + m * σ[Close, n]
UBB– Upper Bollinger Band
LBB– Lower Bollinger Band
SMA– Simple Moving Average
N– Number of periods (typically 20)
m– Number of standard deviations (typically 2)
σ[Close, n]– Standard Deviation over last n periods of Close
The Bollinger Bands can be interpreted in different ways. The most basic form of interpretation is that when the price is close to the upper band, it indicates that the price is expensive. On the other hand, when the price is around the Lower band, it specifies that it is cheap. Also, the standard deviation increases with the expansion in the range of the price and decreases with the reduction in the price range. Therefore, when the Bollinger Bands widens, it implies that the market is highly volatile, and when it narrows, it implies that the market is less volatile.
A technical analyst trader is often interested in those securities whose price is hovering around the outer bands (UBB/LBB) as it indicates some form of resistance (UBB) or support (LBB) in the market. The price tends to retrace to the moving average line when the price moves to the extreme (UBB or LBB). Therefore, the moving average line can act as good entry levels. However, it does not precisely provide a signal for buy or sell. Instead, it determines the relative high and low.
Bollinger Bands is often used in conjunction with other indicators. The other indicators used are those who help in the prediction of the next move in the market. Once the confirmation is obtained from the indicators, the Bollinger Bands is used, only to provide a heads up to the trader that the trade is going to perform in the trader’s desired direction.
How to install Bollinger Bands in MT4 (Step by step process)
Below is the main screen of the MT4 trading platform.
Step1: On the main screen, there exists a navigator toolbox. If not, hit “ctrl+N” to obtain in it on the main screen. From the navigator box, click on the “indicator” option. This displays a set of types of indicators.
Step2: Next, click on the Trend option, which will result in a subset of trend indicators, as shown below.
Step3: Now, select the “Bollinger Bands” indicator, which will open a new window where modifications to the indicator can be done. Here, the period is set to 20 and deviation to 2 by default. It is recommended to start with the default settings initially. Different values can be tried on gaining experience.
Trading strategies using Bollinger Bands
Based on the technical analysis, a couple of strategies are given below.
Strategy 1: When the price is ranging within the boundaries of the Upper and Lower Bollinger bands, a sell can be considered at the Upper Bollinger band area when the price struggles (with less momentum) the way up until the Upper Bollinger band. Contrarily, a buy can be triggered around the LBB when the price struggles the way down until the LBB.
A clear example is given below.
Strategy 2: Bollinger Bands breakout strategy
Before the widening of the band, the price would be in a narrow channel or range. But, when the band widens, it implies that the volatility has increased and also implies that there is a high possibility of a breakout. This indicates a new trend in the market. Therefore, when the price breaks above the Upper Bollinger band and the candle closes above the envelope, a long position can be taken. And, if the price breaks below the Lower Bollinger band and the candle closes below it, the security can be shorted. Hence, we can conclude that, when the price sustains above the upper Bollinger band mark, the market is showing bullishness and when price breaches below the lower Bollinger band mark, it can be said that there is pressure in the market and is showing bearishness.
Example supporting the above explanation.
Important Note: The strategies mentioned above must be used only when all other technical analysis factors are completely satisfied.
Cons of Bollinger bands
The Bollinger Bands is not an independent indicator. It is found to be very useful only when it is combined with a few non-correlated indicators. Another disadvantage with this indicator is that the standard-setting will not work every single time. Hence, the consistency is quite less.
Bollinger Bands is an interesting study that shows the price valuation in relation to the consensus or average price of the period. It also is used to assess the trend direction and volatility of the market.
A broad bandwidth indicates high volatility, and a narrow bandwidth indicates low volatility, and, usually, when the bands spread apart from a narrow period, the price usually starts a new trend.
If the price moves above the mean band and the band points upward the security is in a bullish trend. If the price moves below the mean band and is pointing downwards, the trend is bearish.
A shrinking band, after a period of trending prices, indicates that the trend has stopped and a price consolidation or retracement begun.
The measurement is done using the simple moving average and the standard deviation of the averaged period.
To generate buy and sell signals, it is advisable to combine it with other predictive indicators.