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Getting to grips with technical analysis can seem like hard work. But if you master just one indicator, make it Bollinger bands. You can think of Bollinger bands as the “all-rounder” indicator – they cover a lot of ground and can be a powerful trading tool if you know how to use them. Here’s what you need to know...
What are Bollinger bands?
John Bollinger invented Bollinger bands in 1983, when he was the chief market analyst for the Financial News Network. The indicator can tell you how volatile an asset is at a given point in time, and whether its volatility is increasing or decreasing. This can be useful information if you’re trying to buy near the bottom, sell near the top, or just sit back and stay in your trade.
The best way to explain Bollinger bands is with an example. And since we’re talking about volatility here, we’ll use the price of bitcoin (black line) as our guinea pig.
There are three important lines on this chart, and together they make up the Bollinger bands: the middle band is the 20-day moving average of bitcoin’s price (blue line). This is a constantly updating, or “moving”, average of bitcoin’s price, representing where its price has been over the past 20 days. The upper band is the middle band plus two “standard deviations” of volatility (grey line, top). And the lower band is the middle band minus two standard deviations of volatility (grey line, bottom).
The standard deviation is essentially the asset’s volatility: when the bands get wider, it means that volatility has gone up, and when they get narrower, it’s because volatility has gone down. Notice how the bands got wider as bitcoin had big drops in price, but became narrower when it was in a tighter trading range.
You can also see how the price stays inside the Bollinger bands (grey area) most of the time, with any movements outside of the bands considered to be extreme. According to Bollinger’s research, the price of any investment stays within the upper and lower bands about 95% of the time.
So how do you use Bollinger bands in your strategy?
Whether you’re a short-term trader or a longer-term investor, there are a few ways that Bollinger bands can help you with your strategy:
Preparing for a big move.
Investments constantly shift between phases of high and low volatility. And when the volatility is lower for longer, you can typically expect a much bigger price move to come, as that volatility eventually returns. Traders call this a “Bollinger band squeeze” or “pinch”. You can see examples of this playing out with the price of gold:
Keep in mind that those major moves after Bollinger band squeezes can be in either direction. And while that might not tell you whether it’s time to buy or sell, times of low volatility can at least alert you of a big potential trading opportunity ahead.
Buying during a "W" bottom in the price
Bollinger studied countless price charts and found that most downward trends end with some type of “W bottom” pattern, where the price makes at least two similar lows before starting a new leg up. Here, the price of an investment bottoms slowly and steadily as buyers gradually gain more confidence, rather than quickly and sharply as with a “V-bottom”.
Bollinger bands can help you decide if a W bottom pattern is more likely to play out and lead to a rally. The chart below is a great example of this, with each bar representing one week of movement in the US dollar index. The first low happened when the bands were wider, meaning the low happened with high volatility – as the bravest investors bought the first of those dips. The price then rallied for some time, before drifting back down to revisit those earlier depths. That’s when the second low happened: but this time, the bands were narrower, signalling that the price had calmed, and that sellers were losing their control.
Most technical analysts would agree that an upward trend starts when the price makes a higher low than the one before it – yet the first and second low above seem to be at about the same place. But relative to the middle band, the second low is actually a higher low. In other words, the second low is closer to the 20-week moving average than the first, making it a relatively higher low – and that’s good enough for Bollinger band traders to start buying.
As a simple Bollinger band strategy, you’d typically want to buy when the price gets above the middle band after its second low, and place your stop loss just below the second low. You’d then want to stay in the trade so long as the price is finishing (i.e. “closing”) each week above the middle band.
Here’s another more recent example with UK government bonds, except this time, each bar represents one day of price movement – so you’d want to stay in the trade so long as the price is closing each day above the middle band:
Selling or shorting after an "M top" in the price
Bollinger studied topping patterns too, and found that “M tops” are fairly common. And it makes sense: after the first top and subsequent drop, dip buyers step in, thinking that they’ve bought in at a bargain. But once the price puts in its second top, they realize the forces of gravity are working against them, as the price drops lower once more.
Below we have an example of an M topping pattern for Brent crude oil on the weekly time frame (where each bar is one week of price movement). Notice how the first high happened with massive volatility, showing that buyers were extremely euphoric at that point – it’s the type of thing you usually see when asset prices reach their peaks.
The price that week spiked way outside of the top band, showing that the bulls were flying too close to the sun. Dip buyers then stepped in after the drop, but that volatility had cooled off, so the price stalled, and the second high was put in. A simple trade idea here, for example, would have been to short oil once its price closed the week below the 20-week moving average (i.e. the middle band), and stay short until it closed a week back above it. And according to Bollinger, you’d want to place your stop loss somewhere just above the second high to manage risk.
So how can you find and use Bollinger Bands?
As with most technical indicators, TradingView is an easy tool to use if you’re looking to add Bollinger bands to your strategy. To do that, you just need to follow these steps:
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