Indicators: How To Trade with Bollinger Bands

Submitted by ChartSecret.com on Wed, 07/01/2009 - 20:48
in

Developed by John Bollinger, The Bollinger Bands is one of the most popular technical indicators. In this indicator I will describe its strengths and weeknesses and show you the ways to use it.

Calculation
The Bollinger Bands consist of 3 bands:

  • Middle Band - A 20-period Simple Moving Average of close price.
  • Upper Band - Middle Band, plus two standard deviations.
  • Lower Band - Middle Band, substracted two standard deviations.

Standard deviation is a statistical study that measures the variable volatility - in trading and FOREX, it measures the volatility of the currency pair or commodity. The Bollinger Band enables the trader to see the location of price in relation to its volatility and range.

Use 1: Support and Resistance
The Bollinger Bands are first of all used to define boundries for price - Support and Resistance levels which are hard to break. This can help us cross-verify trades and enhance the quality of our trades, by requiring that price is near Lower band for long trades, and near Upper band for short trades.

This confirmation is especially powerful when the Middle Band is flat, and not trending. This indicates that trend is weak, and ranging trades are stronger than breakout trades.


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Use 2: Identify Ranges and Trends
The Bollinger Band can easily identify periods of trend and range, helping the trader customize his trading style and choosing which trades to pick. This is done by looking at the Middle Band. The 20-period SMA identifies trends and ranges by its slope. If it is strongly trending it indicates a strong trend period. If it is flat and non-moving - it indicates a period of range. In ranging period we would take more trades on support and resistance - reversal trades - while in period of strong trend we will attempt to join the trend on retracements and pullbacks.

The Middle Band can be a strong confirmation sign for all your trades, and will greatly improve your trading by limiting you to trade based on the phase of the market. Most traders disregard this separation between trend and range but this is crucial for your trading success. By changing your trading style and adapting it to the phase of the market, you increase your win probability and improve your overall performance.

Also note that in periods of strong trend the Middle Band (Simple SMA) will often be used as a barrier for price, and it will block many trades from going against the direction of the main trend. Make sure to wait until Moving Average is flat before trading against its direction.

Use 3: Detect Volatility and 'Squeeze'
As mentioned, the Bollinger Bands are ment to display the market volatility - wide bands indicate high volatility and tight bands indicate low volatility of pair. There is a special way of trading that exploits periods of extremely low volatility - that explode to big trends. This is called the 'Squeeze'. A period of low-volatility where candlesticks are 'squeezed' inside the Bollinger Bands, and have small margin for range. This period usually results in a high-volume breakout and a big trend.