Using Bollinger Bands to Gauge Trends

A tag of the lower Bollinger Band® is not in and of itself a buy signal. The middle band is a simple moving average that is usually set at 20 periods. A simple moving average is used because the standard deviation formula also uses a simple moving average. The look-back period for the standard deviation is the same as for the simple moving average. The outer bands are usually set 2 standard deviations above and below the middle band. Such techniques usually require the sample to be independent and identically distributed, which is not the case for a time series like security prices.

A squeeze occurs when volatility falls to low levels, and the price starts moving sideways in a tight consolidation, narrowing the bollinger bands. In a different example, Yahoo broke the lower band on December 20, 2006. The strategy called for an immediate buy of the stock the next trading day. When the bands squeeze together, it usually means that a breakout is getting ready to happen. If you’re freaking out because you’re not familiar with standard deviations. The middle line of the indicator is a simple moving average (SMA).

Introduction to Bollinger Bands

A simple way to spot a squeeze is to identify when the bands are the narrowest they have been for the last six months. It happens when price action spikes the lower line and then recovers, establishing the first low. Then after a while, another low is established, and this time it is above the lower band. We introduce people to the world of trading currencies, both fiat and crypto, through our non-drowsy educational content and tools. We’re also a community of traders that support each other on our daily trading journey.

The strategy called for a buy on the stock the next trading day. Like the previous examples, the next trading day was a down day; this one was a bit unusual in that the selling pressure caused the stock to go down heavily. The selling continued well past the day the stock was purchased and the stock continued to close below the lower band for the next four trading days. Finally, on March 5, the selling pressure was over and the stock turned around and headed back toward the middle band.

Bollinger bands outside of finance

Conversely, a breakout to the downside signals traders to open short positions or exit long positions. A stop-loss order is traditionally placed outside the consolidation on the opposite side of the breakout. For example, a false breakout happens when an asset’s price passes through the trade entry point. It signals a trade but then moves back in the other direction, resulting in a losing trade. Our simple Bollinger Band® strategy calls for a close below the lower band followed by an immediate buy the next day.

• During these conditions, there is no way of knowing when the selling pressure will end.
• The selling continued well past the day the stock was purchased and the stock continued to close below the lower band for the next four trading days.
• When the price of the asset breaks below the lower band of the Bollinger Bands®, prices have perhaps fallen too much and are due to bounce.
• A Bollinger Band consists of a middle band (which is a moving average) and an upper and lower band.
• In a strong downtrend, the price will run along the lower band, and this shows that selling activity remains strong.
• When RSI is near an extreme high (~100) or low (~0), and is touching either the high part of the upper band or the low part of the lower band, the RSI line could pull back sharply from the band.

Most technical traders aim to profit from the strong uptrends before a reversal occurs. Once a stock fails to reach a new peak, traders tend to sell the asset at this point to avoid incurring losses from a reversed trend. Technical traders monitor the behavior of an uptrend to know when it shows strength or weakness, and they use this as an indication of a possible trend reversal. By default, a 20-period SMA and 2 standard deviations are used to calculate the Bollinger Bands. However, since P&F moving averages are double smoothed, it may be necessary to shorten the moving average period when placing this overlay on a P&F chart. However, the reaction highs are not always equal; the first high can be higher or lower than the second high.

Trading guide

As Bollinger puts it, moves that touch or exceed the bands are not signals, but rather “tags”. On the face of it, a move to the upper band shows strength, while a sharp move to the lower band shows weakness. It takes strength to reach overbought levels and overbought conditions can extend in a strong uptrend. Similarly, prices can “walk the band” with numerous touches during a strong uptrend. The upper band is 2 standard deviations above the 20-period simple moving average.

• We’re also a community of traders that support each other on our daily trading journey.
• We know that markets trade erratically on a daily basis even though they are still trading in an uptrend or downtrend.
• When that happens, a cross below the 20-day moving average warns of a trend reversal to the downside.
• Bollinger Bands® can be a useful tool for traders for assessing the relative level of over- or under-sold position of a stock and provides them with insight on when to enter and exit a position.
• To effectively use this strategy, a good exit strategy is in order.
• A Bollinger Band® is a technical analysis tool defined by a set of trendlines.
• Because Bollinger Bands measure volatility, the bands adjust automatically to changing market conditions.

The second number (2) sets the standard deviation multiplier for the upper and lower bands. These default parameters set the bands 2 standard deviations above/below the simple moving average. A Bollinger Band overlay can be set at (50,2.1) for a longer timeframe or at (10,1.9) for a shorter timeframe. Although https://www.bigshotrading.info/blog/what-is-the-stochastic-oscillator-and-how-to-use-it/ are helpful tools for technical traders, there are a few limitations that traders should consider before using them.

How To Calculate Bollinger Bands

He suggests using the relative strength index (RSI) along with one or two volume-based indicators such as the intraday intensity index or the accumulation/distribution index. Most technicians will use Bollinger Bands® in conjunction with other indicators, but we wanted to take a look at a simple strategy that uses only the bands to make trading decisions. It has been found that buying the breaks of the lower Bollinger Band® is a way to take advantage of oversold conditions.

• Technical analysis is a trading strategy that analyzes statistical trends to identify trading opportunities.
• Many traders believe the closer the prices move to the upper band, the more overbought the market, and the closer the prices move to the lower band, the more oversold the market.
• A squeeze occurs when volatility falls to low levels, and the price starts moving sideways in a tight consolidation, narrowing the Bollinger Bands.
• Bollinger Bands® is not a standalone trading system but just one indicator designed to provide traders with information regarding price volatility.
• In the NYX example, the stock climbed undaunted after it closed below the lower Bollinger Band® a second time.

Settings can be adjusted to suit the characteristics of particular securities or trading styles. Bollinger recommends making small incremental adjustments to the standard deviation multiplier. Changing the number of periods for the moving average also affects the number of periods used to calculate the standard deviation.