Bollinger bands refer to a versatile technical analysis tool developed in 1980 by John Bollinger. Compared to other signal indicators, Bollinger bands are straightforward, allowing traders to use them on various trading platforms in conjunction with other indicators to make better trading decisions.
Since their inception, Bollinger bands have proved to be an effective solution to anticipate market price movements in various financial assets, including forex, cryptocurrency, indices, and stocks. However, making the right decisions using Bollinger’s analysis tool requires factual information and knowledge of how to read Bollinger bands. Similarly, it would be best to understand how they work and their application in financial markets.
What are Bollinger Bands?
Bollinger Bands are described as price envelopes because they define the upper and lower price limits of financial assets. Generally, Bollinger bands form a channel around asset price movements based on a moving average and standard deviation. As a result, Bollinger bands can help you establish current market trends, the direction of future trends, potential price reversals, and volatility, as long as you follow standard guidelines.
Although Bollinger bands are inherently considered lagging indicators due to their reaction to price movements, they have an outer band and a moving average that qualify them as leading indicators. In other words, you can use Bollinger bands to identify points where asset prices may stall or reverse. Similarly, you can use Bollinger bands to determine whether a particular financial instrument is oversold or overbought.
The Basic Components of Bollinger Bands
Bollinger bands comprise three separated bands that operate in unison, including the upper, middle, and lower bands. The upper and lower bands are plotted above and below the middle band, which constitutes a Simple Moving Average (SMA). While the upper band indicates the SMA plus two standard deviations, the lower band indicates the SMA minus two standard deviations. However, the distance between these bands and the SMA contracts when the market is calm and expands with increased volatility. On the other hand, the SMA indicator comes with a period of 20 by default but allows you to customize these combinations according to your preferences.
Bollinger bands also have an indicator that measures the distance between the upper and lower bands, known as the Bollinger bandwidth. Therefore, the bandwidth is the difference in value between the upper and lower bands. On that account, a higher bandwidth indicates high prices, and a lower bandwidth indicates lower-priced stocks. However, traders should be careful to note actual price differences because a stock price of 100 and bandwidth of 5 will suggest that the bandwidth is 5% of the price. Similarly, a stock price of 20 and bandwidth of 1 will also show the bandwidth as 5% of the stock price.
How to Read Bollinger Bands
Bollinger bands have limited components, making them easy to read and assess. When the distance between the upper and lower bands is tight during low volatility (Bollinger Squeeze), there is an increased likelihood of a sharp price shift either up or down, indicating the beginning of a trend. However, it would help if you watched out for a false price move in the opposite direction, which reverses before the main trend begins. Subsequently, when there is a vast distance between the bands, this shows increased volatility and the end of a trend.
Stock market prices tend to bounce within the bands by touching one band and moving towards the middle to the other band, a state known as the Bollinger bounce. Therefore, every time the stock prices touch one band, expect them to touch the adjacent band. Therefore, you can observe these swings to identify your next profit target, making Bollinger bands a reliable tool for swing traders.
Stock prices can also rise over the band or envelope only one of the bands for an extended period because of strong trends. If you are a swing trader, you should consider additional research to determine whether taking your profits is appropriate. Although the continuation of a strong trend occasionally occurs when the price rises or falls out of the bands, a price movement that directly goes back into the bands suggests that the market price is negated.
How to Use Bollinger Bands to Identify Reversals
Familiarizing with how to read Bollinger bands can also help you to identify trend reversals when trading. If the stock price is at an uptrend and continuously hits the upper band, a sudden decrease to hit the lower band could signify a reversal. Even if the price regains momentum towards the upper band, it can hardly reach your recent high price. On the other hand, if the price showcases a downward trend that continuously hits the lower band and it shifts to hit the upper band, this indicates a reversal. If the price declines again, it will not hit the lower band.
Limitation of Using Bollinger Bands
A common limitation of using Bollinger bands as stand-alone indicator is their reliability. Just like all other indicators, Bollinger bands are not perfect. Therefore, they can produce inaccurate readings depending on the band settings and the featured asset. The creator of Bollinger bands recommends using the tool together with two or three other nonrelated indicators to provide more targeted market signals. As a result, you can adopt tools like the moving average divergence or convergence (MACD), Relative Strength Index (RSI), and the On-balance Volume. However, occasionally evaluating your results on a particular asset is a solution to determine its reliability. If the standard settings are not working, you can change the band settings to identify values that work most of the time.
Although Bollinger bands do not produce reliable information sometimes, they can assist you in arriving at a strategy that works for various market instruments. Contrary to the notion that trading instruments are complicated to incorporate into most stocks or indices, Bollinger bands are a comprehensive technical analysis tool used by traders on various financial instruments globally. However, successful trading requires perfecting how to read Bollinger brands, proper risk management, and reliable entry and exit points. Nonetheless, experimenting with Bollinger bands and various analysis tools will enable you to improve your trading skills and reap desired profits.