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#1 12-10-2021 11:12:09

Admin & Trader
From: Paris - France
Registered: 21-12-2009
Posts: 3176

Trading with Bollinger Bands

Trading with Bollinger Bands

Bollinger bands use the concept of a simple moving average - which takes X number of previous prices and smooths them over a set period (e.g. 20 periods / days, 50 periods / days) to see how far the current price is from the average. This moving average is accompanied by two separate lines, usually drawn two standard deviations above and below it.

The upper and lower lines can be set to a different parameter based on user input, for example 1.5 standard deviations or 3 standard deviations from the mean.

Bollinger bands using the standard setup of a 20-period simple moving average and bands with two standard deviations from the mean are known as the setting (20, 2). Virtually any trading software will allow you to adjust this setup, including going from a simple moving average to an exponential moving average.

Bollinger bands are commonly used as a "mean reversion" indicator. If the price is below the Bollinger Bands, this can be taken as an indication that the price is currently too low. Likewise, if the price is above the bands, it can be interpreted as being too high. Bollinger bands are also commonly used as an indicator of volatility. When the price is volatile, the bands widen; when volatility is low, the bands contract.

Some traders may interpret the indicator in a different sense. If the price is trading outside the bands, but the trend is in the general direction of the indicator - which is basically just three separate but parallel moving averages - the Bollinger Bands can be seen as a tracking indicator of tendency.

Bands can also be viewed as a simple indicator of volatility. When the bands contract due to a period of low volatility, commonly known as a "squeeze," it may indicate a period of high volatility ahead. Conversely, if the bands widen, it could indicate a period of low volatility ahead. Those in need of volatility or a trending market are likely to close out trades or reduce their positions during times of band expansion.

Example 1

Here we have an H1 chart of the S&P 500 with Bollinger Bands set to (20, 2).

Some traders interpret the close of a full candle outside the bands as a trading signal that the price is oversold (if it's below the band) or overbought (if it's above the band). Trading opportunities can therefore be biased in the opposite direction.

Traders using the bands in this direction would do the reverse of a trend following system, unless they are following the trend over a longer chart period and the Bollinger bands over a separate smaller period. For example, if a trader only considered long trades based on the trend of the daily chart, but saw an hourly candle close completely below the lower Bollinger Band, he might consider going long on the asset.

Example 2

If we use the same chart but with the parameter (20, 3), it will produce more conservative signals for potential "mean reversion" opportunities. Of course, the bands are much wider. A parameter with three standard deviations would theoretically take into account 99.7% of the price data rather than only 95% of the price data.

As you can see, the signals, based on the candles leaving the bands, are few and far between.

Example 3

We can also shorten the 10 period moving average. If we keep the standard deviation parameter at 2 for a parameter (10, 2), we get the following:

Since the period is shorter - the moving average takes into account the last 10 periods of price data rather than going back 20 periods as in the case of the default - the bands are much more sensitive to the current price. This means that the price data is more likely to stay in the bands, as the minute-by-minute price is more strongly integrated into the formulation of the indicator.

Example 4

As a general rule, the shorter the period and the higher the standard deviation, the more likely the current price is to be in the bands. If we extend the period to 200 and reduce the standard deviation to only 1 (i.e. (200.1) as shown below), the indicator has very little value.

"Anything worth having is worth going for - all the way." - J.R. Ewing



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