John Bollinger, a trader and financial analyst, is best known for his contribution to the field of technical analysis with his development of Bollinger-Bands in the 1980s.Bollinger Bands
Bollinger-Bands are one of the most popular technical indicators available, and often the one of the first that beginning traders learn to use.
Like all technical indicators it can be used in the trading of any asset, such as a stock or ETF share, or a commodity like gold or oil.
There are both pros and cons to using Bollinger Bands. Here is what you need to know before using them in trading.
What Are Bollinger-Bands and Why Are They Useful?
Bollinger-Bands use three bands made up of moving averages. The bands are plotted as lines on a trading chart. The three bands include a 20-day simple moving average and upper and lower standard deviations (SD) on that moving average.
- Middle band: 20-day simple moving average
- Upper band: 2 standard deviations above the middle band
- Lower band: 2 standard deviations below the middle band.
(Note: the 20-day simple moving average and the 2 standard deviations above and below are default values for Bollinger Bands.)
By using a moving average, Bollinger Bands are able to filter out much of the noise created by random price fluctuations to provide an indicator of future price fluctuations.
When the top and bottom bands contract (meaning they are closer to each other and the current price indicator), the underlying price is considered less volatile, while the expansion of Bollinger Bands indicates that the price may be about to breakout higher or lower.
When prices repeatedly touch the top of the Bollinger Band, this may indicate that the underlying asset is overbought (and may be worth selling). If prices repeatedly touch the bottom band this may indicate prices are oversold (and may be worth buying.)
For example, FXWirePro uses Bollinger Bands in this EconoTimes post about the daily outlook of AUD/USD. Because the Bollinger Bands are shrinking, volatility in the market is likely low.
Breakouts and Head Fakes
One of the simplest ways to use Bollinger Bands is to watch for the bands to contract as the trading range narrows. This is called the “Squeeze.”
The Squeeze precedes a movement up or down in price. However, at the end of a Squeeze, there’s often a phenomenon called a “head fake” where the price seems to be going in one direction then abruptly changes course and heads in the opposite direction.
To avoid being fooled by a head fake you can :
- Wait to confirm price direction
- And use the Parabolic SAR indicator to confirm imminent price direction.
Pros and Cons of Bollinger-Bands
Bollinger Bands are a classic trading tool useful in acting on changes in volatility and price direction. It’s typically used in conjunction with other tools.
Pros of Bollinger Bands :
- Can provide early indication of price reversals
- Signals changes in volatility
- User-friendly tool for beginners and experienced traders.
Cons of Bollinger Bands :
- Head fakes may trip up inexperienced traders
- The ease of use may give beginner traders a false sense of security
Bollinger Bands are a versatile technical analysis tool that most users find easy to understand. However, like most analysis tools, they should be used together with other technical indicators and with fundamental analysis.