Understanding bollinger bands
What are Bollinger Bands?
A Bollinger Band is a technical analysis indicator used to measure market volatility. Simply put, the indicator tells whether the market is in a period of low or high volatility, depending on the size of the bands and how prices oscillate.
A Bollinger band primarily consists of a set of lines plotted from a simple moving average that can be adjusted to fit any trading strategy. The standard deviation aspect is the measure of volatility in the bands.
For instance, whenever the market is highly volatile, then the bands would widen and narrow whenever the market is less volatile. Bollinger bands show levels of highs and lows when it comes to price action.
The Bollinger Bounce
The Bollinger Bounce is an aspect of Bollinger Bands whereby price tends to move to the middle of bands from time to time. A look at the chart above, it is clear that price had the tendency of moving to the middle of the bands on its way to the topmost or lowermost level of the band.
The bounce occurs because the Bollinger bands act as levels of support and resistance from which traders enter and exit positions, triggering price movements. The utmost level of a Bollinger band is often seen as a statistically high or expensive level; thus, the reason why traders exit positions or enter sell positions. Conversely, the lower band is often seen as a low or cheap level, consequently attracting buy orders.
The bounce that occurs at the bands has made Bollinger bands ideal trading indicators for range-bound markets.
In addition to being effective in range-bound markets, Bollinger Bands also find great use in trending markets. Bollinger Squeeze refers to the narrowing of Bollinger bands, signalling a potential breakout on the horizon.
Whenever the bands constrict and come close to each other, it is always indicative of low volatility, signaling potential future build up in volatility. The wider apart the bands are, the likelihood of volatility decreasing after some time on traders exiting positions after a spike.
After the narrowing of the Bollinger bands, whenever candlesticks start to break out above the topmost band, then the price of the underlying asset will make most of the time edge higher. Conversely, whenever candlesticks start to breakout below the bottom band, then the price will usually edge lower, indicating the formation of a downtrend.
Breakouts above or below Bollinger bands occur from time to time, mostly as a result of a major event. While the breakouts are always indicative of strength in a given direction, they should never be relied upon as trading signals. A breakout could trigger oversold or overbought situations whereby price could bounce back or collapse afterward.
In addition, whenever new highs and lows are made outside the Bollinger bands followed by highs and lows inside the bands, the same could signal a potential trend reversal on the prevailing trend.
Bollinger bands, just like any other indicator, should never be used independently. The fact that they provide information about the level of volatility in the market means they should always be used with other indicators in a trading strategy. Some of the indicators that one can use in tandem with Bollinger bands include Moving Average Divergence and Convergence indicator or Relative Strength Index.