Bollinger Bands is a technical analysis tool developed by John Bollinger in the early 1980s.
Bollinger bands consist of three curves drawn relative to price. These three curves are the upper band, the lower band, and the middle band. The middle band is, as a general rule, a simple moving average and, therefore, provides us with information about the trend. From the middle band, the upper and lower bands are calculated using a standard deviation. The interval between the upper and lower bands gives us information on the volatility or activity of the market. By default, the parameters are simple moving average of 20 periods and 2 standard deviations for the calculation of the upper and lower bands. (Note: on some platforms and graphical analysis software the middle band is not displayed).
As you can see, the Bollinger bands provide us with double information: trend and volatility. When the market is calm the Bollinger bands contract, when the market is more active the Bollinger bands expand.
This is because the standard deviation can be interpreted as a measurement of volatility, therefore, as volatility increases, the value of the standard deviation increases, and it is visible in Bollinger bands as an expansion of them. Similarly, as volatility decreases, the standard deviation decreases, which is reflected in the Bollinger bands as a contraction, leaving the upper band and the lower band closer together.
Most common uses
Let’s take a look at the two most used Bollinger Bands strategies, the Bollinger Bounce and the BollingerSqueeze.
Bollinger Bounce, this is the bounce in the Bollinger bands.
The price tends to return to the middle zone of the Bollinger bands, much more in periods in which the market moves laterally or in ranges. This idea can be useful in our trading to determine maximum and minimum points as well as entry and exit levels of the market.
The reason this bounce occurs is because the Bollinger bands act as minor support and resistance. On longer period charts (H4, D1) the resistance represented by Bollinger bands will be stronger than on shorter period charts. Remember that if there are strong trends the Bollinger bounce will not work.
Following the Bollinger Bounce, we can have two situations, a price rebound in the upper band towards the middle zone or a rebound in the lower band.
We have seen the Bollinger bounce that works very well in markets with lateral movements, and how will Bollinger bands behave in markets with strong trends?
As we said, Bollinger bands can inform us of both market volatility and trend. An effective way to combine both data is through the so-called Bollinger Squeeze (Bollinger contraction).
In markets with trend movements, a good entry can be after a period of calm, a period that will be indicated by a contraction of the Bollinger bands since during this period volatility will decrease.
Where a period of calm, low volatility and little market movement, Bollinger bands will contract forming a narrow and practically horizontal channel. In this situation, a break to one side or the other is to be expected to take place. If a candle breaks the level marked by the lower band, it is expected that the price will continue to fall. Similarly, if after the formation of this narrow channel delimited by the Bollinger bands, a candle rises above the level marked by the upper band, it is to be expected that the price will continue to increase. Let’s look at an example of a lower band breakout.
If you want more information and deepen in the Bollinger bands do not miss this site: http://www.bollingerbands.com