Trading with Bollinger Bands | FXTRADING.com - International

Trading with Bollinger Bands

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Bollinger bands are a versatile indicator which are used widely among discretionary and automated traders. Blending statistical theory with price action, they can be a useful tool to identify mean reversion and breakouts.

According to John Bollinger, the creator of the Bollinger Bands in the early 1980’s, Bollinger Bands are adaptive trading bands which are applicable across most timeframes and all financial markets (forex, equities, commodities and bonds). Previously, envelopes were a popular tool to use as bands around a moving average. Yet as envelope bands are fixed, they do not capture the dynamics of volatility. Bollinger Bands fixed this problem.

Bollinger Bands:

  • Show relative highs and lows of price
  • Combine the idea of dynamic envelopes with standard deviation (SD)
  • Incorporate market volatility with moving average analysis

Bollinger Bands are an indicator which sit alongside price action, and it is how price interacts with the bands which are of importance. This is unlike indicators which go beneath the price chart and studied separately to price, such as the RSI (Relative Strength Index) or stochastic oscillators.

By default, a 20-period simple moving average (sMA) of the closing price is used, then two standard deviations are applied above and below the sMA. According to statistical theory, around 95% of data should land between these two bands. This is why it can be used for mean reversion, as price action can show a tendency to ‘snap back’ and revert to the mean if it touches the upper or lower band (but not always as we’ll demonstrate).

Default settings of Bollinger Bands:

  • Centre band: 20-period simple moving average (sMA)
  • Upper band: +2 SD (standard deviations)
  • Lower band: -2 SD (standard deviations)

Whilst variations of Bollinger Bands have used an exponential moving average, the original uses an sMA as this also forms the basis of the classic standard deviation calculation. Users can increase or decrease the length of the moving average and standard deviation settings, but you will usually see these settings by default.

 

Bollinger Bands Have Multiple Uses
Bollinger bands are a popular tool with chart traders for several reasons.

  1. They clearly show price extremes (price action highs or lows relative to moving average)
  2. Warn of overbought / oversold conditions (OB/OS)
  3. Show levels of volatility
  4. Anticipate breakouts
  5. Project price targets

Yet they are also popular with automated traders as they can happily form the basis of a trading system using its statistical measure of volatility, price targets and OB/OS abilities.

Bollinger Bands Can Warn of Overbought / Oversold Conditions
Bollinger bands are one of the few indicators which interact with price action whilst also warning of overbought and oversold conditions.

  • When prices rise to the upper band, the market may be approaching ‘overbought’
  • When prices fall to the lower band, the market may be approaching ‘oversold’
  • Some traders look for reversal candles closing on / around a bollinger band to warn of a reversal
  • Bollinger Bands are more effective at highlighting potential overbought and oversold conditions during a sideways or oscillating market

That said, it doesn’t necessarily mean prices will instantly reverse as price action may make several attempts to breakout of the bands, or simply consolidate in that area and not reverse at all. Or worse still, prices could simply breakout of the bands and mark the beginning of an extended move as part a new trend.

Like oscillators, Bollinger Bands are more effective at highlighting potential overbought and oversold conditions during a sideways or oscillating market. It is therefore best to use other forms of technical analysis to better identify the conditions of price action before assuming prices have hit an inflection point.

For example, some traders could use two or more closes outside of the bands to mark a possible breakout and refer to volume analysis to see if trading activity has increased at the possible breakout point. Whereas multiple candles which have failed to close beyond the bands could suggest with a higher probability that prices could revert back towards the mean.

Bollinger Bands Can Show Levels of Volatility

  • When volatility increases the bands widen
  • The bands narrow when volatility subsides
  • Traders monitor the bands width and how prices interact with them

When the bollinger bands widen, it shows that volatility has increased and when they narrow, volatility has decreased. As the upper and lower bands are standard deviation added and subtracted from the mean, we have placed a 20-period standard deviation indicator to show how it increases and decreases with Bollinger Band width.

Whilst a shift in volatility can also be seen on price action alone, bollinger bands provide a quantified look at volatility and help highlight potential inflection points on price action.

Bollinger Bands Can Anticipate Breakouts

  • When the bands become narrower it provides a warning of a potential breakout
  • However, the bands do not provide a likely direction to the breakout
  • False starts are not uncommon, where price breaks out in one direction but then reverses
  • Sometimes these false breaks turn into a trend in the opposite direction

When Bollinger Bands tighten, they can sometimes warn of a pending breakout, and is famously known as the “Bollinger Band Squeeze”.  Another way to phrase this is to say that Bollinger Bands can warn of range expansion following periods of price compression. But the squeeze is believed to be more effective when the bands squeeze tightly together, and it is assumed that the tighter the range and longer it persists, the greater the breakout can be.

However, it doesn’t necessarily predict the direction the breakout will take or when it may occur. Again, other forms of analysis such as trend analysis may be required to assess whether a bullish or bearish breakout is more likely.

One approach some traders take is to wait to see if prices reverse after the breakout and use it as a contrarian signal such as a bull or bear trap.

Bollinger Bands Can Provide Profit Objectives

  • The upper, lower and centre bands can provide profit objectives
  • This effectively makes them targets for mean reversion traders
  • Use the moving average and / or the opposite band as an initial target
  • However, the method is not perfect as these targets will move over time

Bollinger Bands can be used to project profit targets if a reversal appears to occur at an opposing band. For example, if a trader decides there is a potential reversing occurring at the upper band, they could use the centre and lower bands are profit objectives for a short position. Conversely, if they believed a bullish reversal is about to occur at the lower band, the centre band or upper band could provide a profit objective for a bullish position.

Ultimately the bands are being used as a mean reversion tool. Although if one is to use the opposite band as a target they are assuming overshoot once prices have travelled through (or mean reverted beyond) the centre band. Some traders wait to see price action form a top at the upper band, or trough at the lower band before assuming prices will revert to the opposite band. A more conservative approach is to assume mean reversion, and that prices will move back towards the centre band.

However, there is an underlying flaw with this approach as the bands move over time, therefore the opposite band may end up being nowhere near the initial target depending on how quickly price action takes to move to the opposite band as the volatility will change the band’s width.

Again, it would be useful to incorporate other forms of analysis instead of simply trading around the bands. For example, a more reliable signal may be provided by combining the Bollinger Bands with a stochastic oscillator or RSI. Or a signal could be ignored if momentum which initially took price action to the band is very strong, as this could suggest a breakout in the wrong direction.

Experimenting with Bollinger Bands
It can be a good idea to experiment with indicator settings or layer them together to reveal different information about price action. For example, to try and identify longer-term reversal points, a trader could use two Bollinger Bands with a different length MA, different levels of standard deviation or both.

In this example we have layered a 100-period Bollinger Band with a 20-period one, with both using 2 standard deviations above and below their average. On the USD/JPY daily chart there were two occasions where price action was beneath both the lower bands in 2020 which resulted in a relatively large snap back towards (and beyond) the moving average.

In this example we have layered two Bollinger Bands; both use a 20-period MA but one uses +/- 2x SD (standard deviations) and the other uses +/- 3x SD. This aims to highlight extreme levels of overbought or oversold and reduce whipsaws from assuming a reversal has occurred after closing back inside the upper or lower band.

How to Load Bollinger Bands Onto Your MT4 Chart
There are two Bollinger Bands included with a new MT4 installation. To add them to chart, locate them within the Navigator window and drag them onto the chart.

  1. Navigator window (control + N) > Indicators > Bands
  2. Navigator window (control + N) > Indicators > Trend > Bollinger Bands

Whilst the calculation for the Bollinger Bands are identical between the two supplied indicators, they have slightly different features.

Navigator window (control + N) > Indicators > Bands

  • “Bands” is a ‘custom’ MT4 indicator, which means users can modify the code within MetaEditor to change the indicators functionality, or use the code as part of a trading system or new indicator
  • Only basic parameters can be changed within the ‘inputs’ tab

 

Navigator window (control + N) > Indicators > Trend > Bollinger Bands

  • “Bollinger Bands” is an inbuilt indicator which means the coding cannot be viewed or modified
  • It has extra functionality and allows you to add the Bollinger Band to another price point or indicator. Drag the Bollinger Band onto price action or another indicator and use the “apply to” dropdown menu to choose what the bands are calculated from.

 

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