Bollinger Bands Strategy: All You Need to Know
No trader should ever feel like they’re playing the stock market equivalent of a guessing game. This is why every trader who steps into the market needs a solid strategy.
Trading strategies are the backbone of successful trading as they give structure, discipline, and a clear roadmap for making informed decisions in the fast-paced, volatile world of finance. So, we’re going to introduce you to a game-changing tool that every trader should have in their arsenal.
Let’s talk about the Bollinger Bands strategy.
What are Bollinger Bands?
Bollinger Bands are a popular technical analysis tool that was invented in 1983 by a technical trader named John Bollinger. He designed these bands to provide investors with a higher probability of figuring out when an asset is either overbought or oversold. This said– Bollinger Bands are commonly used as a volatility indicator that traders refer to when they need to identify potential price trends in financial markets.
Because these bands help traders find potential market trends and leverage them for profit, there’s no question that they’re a powerful tool for every trader looking to gain an edge in the market.
Reading Bollinger Bands
To use a Bollinger Bands strategy, you need to know how to use Bollinger Bands. So, let’s go over how to read them.
The formula for Bollinger Bands isn’t too complex. Essentially, these bands consist of three trend lines: a central moving average line, and two outer bands that are set above and below the moving average at a certain distance based on standard deviations.
These three lines provide a visual representation of the price volatility of a particular asset and can be used to identify potential buying or selling opportunities based on whether the price is trading near the upper or lower band. So, let’s go over what each line is and how to calculate it.
The first line
The first line is the central moving average line. This line represents the asset's average price over a specified period and is used as a reference point for the upper and lower bands. This trend line can be a useful tool in a Bollinger Bands strategy because it helps traders identify an asset's overall trend. Plus, it also helps traders determine potential buying or selling opportunities based on the position of the asset's price with the Bollinger Bands.
The second line
The second line in Bollinger Bands is the upper band. This band/line is set a certain distance above the central moving average line. Thus, it represents the upper boundary of an asset's expected price range based on its historical volatility.
For example, when the price of an asset approaches or touches the upper band, it indicates a significant level of price resistance, often called Bollinger Band resistance. This ‘resistance’ tells traders that the price of an asset has a higher probability of encountering selling pressure and potentially reversing its trend or experiencing a pullback.
The distance between the upper band and the moving average line is determined by the standard deviation of an asset's price over a given period. So, the upper band can be a useful boll indicator for traders because it can signal potential selling opportunities when an asset's price rises above the upper band.
The third line
The third line in Bollinger Bands is the lower band, which is the line that’s set a certain distance below the central moving average line. This band represents the lower boundary of an asset's expected price range based on its historical volatility.
The distance between the lower band and the central moving average line is set by the standard deviation of an asset's price over a given period. So, in contrast to the second line (the upper band), this trend line can signal potential buying opportunities to traders when an asset's price dips below the lower band.
By using all three trend lines of Bollinger Bands together, traders can gain an inside look at an asset's volatility and potential price movements.
What Bollinger Bands tell traders
In a nutshell, a Bollinger Bands strategy provides traders with insight into the market direction based on price movements. When prices approach the upper band, it implies that the market may be overbought. Conversely, if prices move closer to the lower or bottom band, the market could be oversold.
How do traders use a Bollinger Bands strategy?
Since these bands tell traders about price movement and the state of the market, many traders use them to compare a stock's location relative to the bands. This allows traders to assess whether a stock’s price is relatively high or low. Also, traders can use a Bollinger Band width indicator to determine a stock’s volatility. Typically, narrower bands suggest less volatility and wider bands suggest higher volatility.
When traders use a Bollinger Bands strategy, they need to be aware of a “Walking the Bands” situation. So, let’s briefly go over what that looks like.
Walking the bands
According to John Bollinger, when prices touch or surpass the bands, they should be considered “tags”– not signals. If prices move toward the upper band, it's a sign of strength, while a quick decline toward the lower band predicts weakness. In a strong uptrend, prices may frequently touch the bands. But, exceeding the upper band requires a significant price movement. Likewise, during an uptrend, it’s common for prices to never reach the lower band at all.
Create your Bollinger Bands strategy
There are many different ways a trader can leverage a strategy based on Bollinger Bands. But, we’ll go over a few popular methods that help traders seek out opportunities in the market.
Bollinger Band squeeze
The Bollinger Bands squeeze is a term used in technical analysis to describe a situation where the bands narrow to a point where they appear to be squeezing the price of an asset. The squeeze occurs when the upper and lower Bollinger Bands move closer together, indicating a period of low volatility.
Traders often see the squeeze as an indicator of an imminent price breakout, as periods of low volatility are usually followed by periods of high volatility. This said, the Bollinger Bands strategy here is to look for a breakout above the upper band or below the lower band as a signal to buy or sell, respectively, when the bands squeeze together.
Scalping with Bollinger Bands
This is a popular trading strategy that involves making short-term trades to profit from small price movements. Scalping with Bollinger Bands uses the bands to find potential price breakouts and to locate entry and exit points for trades.
This approach is all about seizing opportunities in the market when they arise and making quick profits from small price movements. To do this, traders look for assets that are trading in a tight range with the Bollinger Bands close together. When the bands begin to widen, it's a sign that the asset is experiencing increased volatility. This tells traders that a possible price breakout may be imminent. So, traders can swoop in during this short interval and make a quick trade as the asset's price breaks above or below the upper or lower band respectively.
Double Bollinger Band strategy
This strategy uses a pair of Bollinger Bands to screen potential entry and exit points in the forex market. Because this strategy is pretty flexible, traders can leverage it in various market conditions, such as a ranging market, a breakout scenario, or to evaluate the strength of an ongoing trend.
Its objective is to initiate long trades when the price exceeds the upper boundary by one standard deviation. Conversely, it aims to enter short trades when the price dips below one standard deviation.
Bollinger Band bounce
The Bollinger Band Bounce strategy aims to capture profits from the price movements that occur as the price bounces between the upper and lower bands. This said, it’s a great strategy for traders who prefer to make modest demands of the markets. This is because the Bollinger Band bounce involves waiting for the market to rebound from the bands toward the center of the bands. By setting low expectations, it may be possible to minimize the volatility of your account balance over time.
At the end of the day…
The thrilling world of trading is constantly evolving. Thus, it's critical to keep learning and adapting to stay ahead of the curve. But, with a Bollinger Bands strategy in your toolkit, you're now on your way to becoming a more informed and successful trader.