In the world of online trading, it is essential to have effective technical tools that help traders make informed decisions. One of these widely used tools is Bollinger Bands. Developed by John Bollinger in the 1980s, Bollinger Bands are a versatile indicator that provides valuable insight into volatility and potential turning points in financial asset prices. In this article, we will explain what Bollinger Bands are, how they are calculated, their parameters, and some common trading strategies based on this indicator.
What are Bollinger Bands?
Bollinger Bands are a technical indicator made up of three lines on a price chart: a center line and two outer bands. The center line is generally a simple moving average (SMA) for a given period, and the outer bands are calculated by adding and subtracting a multiple of the standard deviation of the prices from the center line. The outer bands are set some distance from the center line and expand or contract based on market volatility.
Bollinger Bands Calculation
Bollinger Bands are calculated in three steps:
- Calculate the Simple Moving Average (SMA) for a given period. For example, a 20-period SMA can be used.
- Calculate the standard deviation of prices based on the SMA. This measures the volatility of the asset. Typically, a standard deviation of 2 is used.
- Calculate the outer bands by adding and subtracting the multiple of the standard deviation to the SMA. For example, for a 20-period SMA and a standard deviation of 2, the outer bands would be calculated by adding and subtracting 2 standard deviations from the SMA.
Bollinger Bands Parameters
Bollinger Bands have two main parameters:
Moving Average Period (SMA): It is the number of periods used to calculate the SMA. A commonly used period is 20, but traders can adjust this value based on their preferences and time horizons.
Multiple standard deviations: This parameter determines the distance of the outer bands from the center line. A commonly used multiple is 2, which implies that the outer bands will be 2 standard deviations from the SMA. However, traders can adjust this value based on the volatility of the asset and their trading strategies.
Trading Strategies with Bollinger Bands
Bollinger Bands are used in various trading strategies. Here are two examples:
1. Band breakout strategy
This strategy is based on the idea that when the price breaks one of the Bollinger bands, it can indicate a strong trend in that direction. If the price breaks the upper band, it is interpreted as a bullish signal, while if it breaks the lower band, it is considered a bearish signal. Traders can open positions in the direction of the breakout and use other confirmation tools to support their decisions.
2. Mean reversion strategy
This strategy is based on the premise that prices tend to return to their mean after moving too far from it. When the price reaches one of the Bollinger bands, there is a chance that it will bounce back towards the center line. Traders can open positions in the opposite direction of the initial deviation, hoping that the price will move toward the moving average.
3. Strategy of opening the bands
In this strategy, traders look for opportunities when the Bollinger Bands narrow, indicating a decrease in volatility. This tightening is expected to be followed by increased volatility and a possible significant price move. Traders can open positions in the direction of the breakout of the bands when there is a sudden increase in volatility.
4. Divergence Strategy
Divergence occurs when the price forms higher or lower highs or lows, while Bollinger bands show lower or higher highs or lows. This can indicate a possible change in the trend. Traders can look for divergences between the price and Bollinger bands to identify possible reversal points and open positions accordingly.
5. Double Bollinger Band Strategy
This strategy involves the use of two sets of Bollinger Bands with different standard deviations. One set of bands is placed with a higher standard deviation to identify larger price movements, while the other set is placed with a lower standard deviation to detect smaller price movements. Traders can use this strategy to identify both stronger trend moves and tighter range moves.
Bollinger Bands are a valuable tool in an online trader’s arsenal. They provide information on volatility and potential price turning points. By understanding how the parameters are calculated and adjusted, traders can use this indicator effectively in their trading strategies. However, it is recommended to combine Bollinger Bands with other indicators and analyses to make more solid decisions and keep in mind that no indicator is infallible.