Bollinger Bands are a great trading tool because they provide a lot of information in one indicator. Basically, the Bollinger Bands can help you with the three following things:
#1 Measuring volatility
#2 Identifying bottoms and tops
#3 Signaling the strength of a trend
In the following article, we walk you through how to use the Bollinger Bands and what to be aware of when applying them to your charts.
The one thing nobody has told you so far about Bollinger Bands
But before we get into how to use the Bollinger Bands effectively, we have to address the biggest unknown fact about Bollinger Bands and why so many people misunderstand them:
Bollinger Bands use CLOSING PRICES. Therefore, closing prices are more important than highs/lows or mid-candle prices.
When you see a wick going through a Bollinger Band, it does not provide a signal or a trigger. Only when a candle closes beyond a Bollinger Band, you have an actual signal. When we come to identifying tops and bottoms, we will explore this in more depth.
#1 Measuring volatility
What is volatility?
When we analyze volatility we have to know what it is and most traders make the mistake that they think volatility shows the strength of a trend.
Volatility describes how much price moves up and down in relation to the average price. So if you see a lot of big candles going up or down, volatility is high. In contrast, when you see the candles trending smoothly without significant candle size and without a lot of up and down, volatility is low. However, you can also have a trending price move with high volatility.
It is important that you understand what volatility is and that volatility is no strength of a price movement.
Bolliner Bands and volatility
Basically, the middle of the Bollinger Bands is a 20 simple moving average and the outer bands are 2 20 simple moving averages placed 2 standard deviations away from the middle. This means that when volatility is high, the outer bands are wider apart and when volatility is low, the outer bands are closer to the center band.
According to Bollinger, the outer Bollinger bands contain roughly 88-89% of price action. A price that can be observed outside the bands, therefore, signals significant volatility.
When Bollinger Bands come in real handy is when we get to identifying reversals, the strength of a trend and observing prices close to, or outside Bollinger Bands later in the article. For now you have to understand that the bands measure volatility and that prices outside the bands are rare and can provide interesting signals. This is especially true for trends.
#2 Using Bollinger Bands to identify tops and bottoms
To keep it simple, we can say that Bollinger Bands can be used to find price divergences and marking tops and bottoms.
3 steps to find a top with Bollinger Bands:
- A trending price move beyond the upper band
- A pullback towards the middle of the Bollinger Bands
- Another move higher (past the previous price high) but not going through the Bollinger Bands
A Bollinger Band top signals losing momentum in an uptrend. It is important to remember that closing prices are more important when using Bollinger Bands to understand the signal. The screenshot below illustrates the point.
On the left side you can see a Bollinger Band top. At point (3) you can see that price is making a higher high and that the wick of the price candles goes through the upper Bollinger Band, but it DOES NOT close above the band. This is Bollinger Band top and signals losing momentum and could be an early warning signal for a reversal.
On the right side you see a MACD divergence with the SAME price chart. As we have seen in an earlier article, a MACD divergence also signals losing momentum because price makes a higher high but the MACD makes a lower high.
#3 Strength of a trending price move
To use Bollinger Bands to know how strong a price movement is, we have to repeat what we have learned so far and what it means for a trend:
- A price close to,or outside the Bollinger Bands signals a price extreme because it does not happen often
– When price moves outside the Bollinger Bands in a trend, it shows extreme strength of a trend.
- Closing prices matter more than mid-candle prices
– When price closes outside the Bollinger Bands in a trend, it shows even more strength.
Now we can analyze how to use Bollinger Bands to identify strong trending price moves with the current EUR/USD price chart. On the left side you can see a chart with only Bollinger Bands on them. As you can see there is a significant downtrend in place and price constantly moves lower close to the outer Bollinger Band and even manages to go outside the band from time to time and it stays below the middle SMA for most of the time. This is a very strong trend and the way the Bollinger Bands help you identify this strength is by analyzing the following points:
- Price stays between the middle SMA and the outer band
- Price stays below the middle SMA and moves along the outer band very closely
- Price closes outside the outer band is another sign of extreme strength. Closes outside the outer band in a trend is a sign of big strength.
To see how the Bollinger Bands work together with other indicators, we plotted the Stochastic indicator on the same chart and you can see it on the right site. You can see that the Stochastic indicator and the Bollinger Bands can be used together:
- While price moves down close to the outer Bollinger Bands, the Stochastic indicator is going down and even entering oversold. Keep in mind: Oversold is NOT showing a reversal. Oversold shows extreme strength. Just like moving along the outer Bollinger Bands.
- Price stops going down and enters a sideways ranging period and even crosses back above the middle SMA at the Bollinger Bands. At the same time, the Stochatic indicator crosses back above as well, confirming the move.
- Shortly after, price never makes it to the upper Bollinger Band and goes back to trending down. When price has been in a significant downtrend and does not make it back to the upper Bollinger Band, it is likely that price might continue the downtrend.
- The Stochastic indicator confirms this specific behavior, crosses back down and enters oversold shortly after while price is back to moving down close to the outer bands and even going beyond them.
Conclusion: Bollinger Bands are a universal weapon for different trading aspects
Bollinger Bands are a great tool because they can do a variety of different things at the same time. The reason for that is because they are very close to the actual price, they consist of different things (a moving average and a standard deviation measurement) and they can be combined with different indicators easily. We can sum up the most important aspects of Bollinger Bands as follow:
- Bollinger Bands are based on closing prices. Therefore, candle-wicks are not as important as candle bodies.
- A close outside the Bollinger Bands shows extreme price levels.
- A price closing outside the outer Bollinger Bands in a trend is signaling significant strength.
- Bollinger Bands can signal price-tops/bottoms that can signal possible reversals.