Bollinger Bands were invented by a renowned technical analyst named John Bollinger in the early 1980s. It was originally developed to measure the volatility of stock prices. This tool is plotted at a distance of two standard deviations from a simple moving average and is used to identify overbought or oversold conditions in the market. It is currently widely used in various financial markets, including equity, bond, and commodity markets.
What are Bollinger Bands?
Bollinger Bands are a technical analysis tool that consists of three lines:
- Middle line: usually a 20-day simple moving average (SMA)
- Upper band: Middle line + (2 × standard deviation)
- Lower band: Middle line – (2 × standard deviation)
The main purpose of this tool is to measure the price volatility of a financial instrument and provide information about potential price movements.
Bollinger Bands Parameter Settings
The following parameters are commonly used for Bollinger Bands:
- Period: 20 days (default)
- Moving Average Type: Simple Moving Average (SMA)
- Standard Deviation: 2
However, traders can change these parameters according to their trading style and market conditions.
Bollinger Bands Explanation
Through Bollinger Bands, we can analyze three main things:
1. Overbought/Oversold Conditions:
- When the price touches the upper band → Overbought Conditions → Possibility of a price drop
- When the price touches the lower band → Oversold Conditions → Possibility of a price increase
2. Volatility Measurement:
- When the band expands → Increased volatility
- When the band contracts → Decreased volatility
3. Price Trend:
- If the price is close to the upper band → Upward trend
- If the price is close to the lower band → Downward trend
Trading Strategies Using Bollinger Bands
1. Range Trading Strategy
- Buy Signal: When the price touches the lower band and bounces back
- Sell Signal: When the price touches the upper band and bounces back
- Stop Loss: Outside the opposite band
- Target: The middle line or opposite band
2. Breakout Strategy
- Squeeze Condition: When the bands are compressed
- Breakout Signal: When the price breaks out of the compressed band
- Confirmation: Breakout with high trading volume
3. Reversal Strategy
- Overbought Condition: Price touches the upper band + RSI in overbought area → Selling opportunity
- Oversold Condition: Price touches the lower band + RSI in oversold area → Buying opportunity
Limitations of Bollinger Bands
- Legacy Indicator: It is based on past data, so it does not predict future movements with certainty.
- Ineffective in trending markets: Price can stay on the same band side for a long time during a strong trend.
- False Signal: False breakouts can occur, especially during low volatility.
- Unable to indicate trend: It cannot indicate market trend on its own.
Effective Use of Bollinger Bands
To get the most out of Bollinger Bands:
- Combine with other indicators (e.g. RSI, MACD)
- Use with price action analysis
- Apply risk management strategies
- Analyze on different timeframes
- Change strategies according to market conditions
Conclusion
Bollinger Bands are a powerful technical analysis tool that, when used correctly, can provide significant assistance in market analysis. However, it is important to remember that no single indicator is completely reliable. Successful trading requires a combination of multiple indicators, proper risk management, and strict discipline.
