Bollinger bands trading strategy is a type of statistical chart characterizing the prices and volatility over time of a financial instrument or commodity, using a formulaic method propounded by John Bollinger in the 1980s. Financial traders employ these charts as visual aids to assess whether an asset’s price is relatively high or low in a recent trading range. The asset is considered overbought if the price is relatively high about the upper Bollinger Band. It is considered oversold if it is relatively low in reference to the lower Bollinger Band.
What Is Bollinger Bands?
Bollinger Band is a technical analysis tool that provides a relative definition of security’s high and low prices. It is composed of an upper band, a lower band, and a middle band. The bands are based on standard deviations and define volatility in the market.
When the market is volatile, the Bollinger Bands expand; during periods of low volatility, the Bollinger Bands contract. The distance between the two bands varies according to market conditions. When prices are close to the upper band, it is considered overbought; when prices are close to the lower band, it is considered oversold.
The purpose of Bollinger Bands is to provide a relative definition of high and low price levels. By definition, prices are high in the upper band and low in the lower band. This relative definition can compare price and indicator actions to arrive at systematic trading decisions.
Bollinger Bands reflect direction, with the 20-period SMA representing intermediate-term trends. Bollinger Bands can recognize patterns and compare the price/indicator relation with the underlying security.
When prices rise or fall rapidly and approach the upper or lower Bollinger Band, it often indicates that prices will soon reverse direction. This is because prices are considered relatively high when they touch or exceed the upper Bollinger Band and relatively low when they touch or drop below the lower Bollinger Band.
Regarding technical analysis, the bollinger bands trading strategy is one of the most popular and widely used tools. Bollinger Bands are a type of statistical chart characterizing the prices and volatility over time of a financial instrument or commodity, using a formulaic method propounded by John Bollinger in the 1980s.
Bollinger Bands consist of three components:
1) A simple moving average (SMA)
2) An upper band corresponding to SMA + 2 standard deviations
3) A lower band corresponding to SMA – 2 standard deviations
The standard deviation measures how widely values are dispersed from the mean. In finance, Bollinger Bands are often used to determine overbought and oversold conditions in the market.
Overbought refers to a situation where the prices have risen too fast and are likely to fall, while oversold refers to a situation where the prices have fallen too fast and are likely to rebound.
Bollinger Bands can be used anytime, but they are most often used on daily or weekly charts.
How to Use Bollinger Bands
There are several ways Bollinger Bands can be used. Some common techniques are:
1) Identifying overbought and oversold conditions: If the price is trading near the upper band, it is considered overbought, and if it is trading near the lower band, it is considered oversold.
2) Identifying trend reversals: If the price breaks below the lower band, it could signal a downtrend, and if it breaks above the upper band, it could signal an uptrend.
3) Making trade entries and exits: Bollinger bands trading strategy can be used to time trade entries. For example, if the price is in an uptrend and breaks above the upper band, that could be a buy signal. Similarly, if the price is downtrend and breaks below the lower band, that could be a sell signal.
4)Setting stop-loss orders: Bollinger Bands can also be used to set stop-loss orders. For example, if you are long a stock and the price breaks below the lower band, you could place a stop-loss order at that level.
5) Using Bollinger Bands with other indicators: Bollinger Bands can be used in conjunction with other technical indicators. For example, you could use Bollinger Bands and RSI to trade divergences.
How to Trade Using Bollinger Bands
There are several different ways to trade using Bollinger Bands. One simple way is to look for price action reversals at the outer bands. Another is to wait for a breakout above or below the bands and then enter the trade in the direction of the breakout.
Bollinger bands trading strategy can also be part of a more complex trading system that includes other technical indicators. For example, some traders may use Bollinger Bands with moving averages. In this case, a buy signal is generated when the price crosses above the moving average and a sell signal is generated when the price crosses below the moving average.
The bottom line is that Bollinger Bands can be helpful for traders, but they should not be used alone. Instead, Bollinger Bands should be combined with other technical indicators to create a complete trading system.
