Contents in this article
Bollinger Bands ® are among the most reliable and potent trading indicators traders can choose from. Bollinger Bands ® can be used to read market and trend strength, to time entries during range markets and to find potential market tops. Bollinger Bands ® are a dynamic indicator which means that they adapt to changing market conditions and, thus, have benefits over other standard indicators which are often perceived as ‘lagging’. In this article, we show you how to use BBollinger Bands ® to improve your chart reading skills and to identify high probability trade entries.
In our pro Forex trading course, you will learn how to use the Bollinger Bands ® to find and time entries step by step.
Bollinger Bands ® explained 101
As the name implies, Bollinger Bands ® are price channels (bands) that are plotted above and below price. The outer Bollinger Bands ® are based on price volatility, which means that they expand when price fluctuates and trends strongly, and the Bands contract during sideways consolidations and low momentum trends.
By default, the Bollinger Bands ® are set to 2.0 Standard deviations. However, we suggest setting the Bollinger Bands ® to 2.5 Standard Deviations to make them wider and capture more price action. With the 2.5 standard deviations, 99% of all price action falls between the two bands, which means that a violation of the outer bands becomes a much more meaningful signal as we will see (watch the video at the end for more info about that).
The center of the Bollinger Bands ® is the 20-period moving average and the perfect addition to the volatility based outer bands.
Trend-trading with the Bollinger Bands ®
In contrast to most other indicators, the Bollinger Bands ® are non-static indicators and they change their shape based on recent price action and accurately measure momentum and volatility. Thus, we can use the Bollinger Bands ® to analyze the strength of trends and get a lot of important information this way. There are just a few things you need to pay attention to when it comes to using Bollinger Bands ® to analyze trend strength:
- During strong trends, price stays close to the outer band
- If price pulls away from the outer band as the trend continues, it shows fading momentum
- Repeated pushes into the outer bands that don’t actually reach the band show a lack of power
- A break of the moving average is often the signal that a trend is ending
The screenshot below shows how much information a trader can pull from using Bollinger Bands ® alone. Let me walk you through the points 1 to 5:
1) Price is in a strong downtrend and price stays close to the outer bands all the time – very bearish signal.
2) Price fails to reach the outer band and then shots up very strongly, even showing an engulfing pattern. This is a classic reversal pattern where the bearish trend strength faded.
3) 3 swing highs with lower highs. The first swing high reached the outer band whereas the following two failed – fading strength.
4) A strong downtrend where price stayed close to the outer band. It tried to pull away, but bears were always in control.
5) Price consolidates sideways, not reaching the outer band anymore and the rejection-pinbar ended the downtrend.
As you can see, the Bollinger Bands ® alone can provide a lot of information about trend strength and the balance between bulls and bears.
After setting your Bollinger Bands ® to 2.5 standard deviations, you will see that price reaches the outer bands less often. At the same time, the meaning of such signals becomes much more important because it shows significant price extremes.
We highly recommend combining the Bollinger Bands ® with the RSI indicator – it’s the perfect match. There are two types of tops that you need to know about:
2) During a consolidation, price spikes into the outer Bollinger Bands ® which get rejected immediately >> Reversal signal into the short direction
The screenshot below shows both scenarios: the first is the market top after a divergence – see how the trend became weaker and lost momentum and then eventually failed to reach the outer Band before reversing. I marked the second spike with an arrow – this was a trend continuation signal as price failed to break higher during the downtrend. The strong spike that was followed by a fast rejection showed that bulls lacked power.
The role of the moving average
During trends, the moving average holds very accurately and a break of that moving average is usually a meaningful signal that the sentiment has shifted. The screenshot below shows nicely how price trended between the outer bands and the moving average both on the way up and down. During the trend, the moving average could have been used as a re-entry signal to add to existing positions during pullbacks.
Furthermore, the moving average can be used as a trade exit signal where a trader does not close his existing positions unless price has broken the moving average. By combining the Bollinger Bands ® with the moving average, a trader can already create a robust trading method.
You can see, the Bollinger Bands ® are a multi-faceted trading indicator that can provide you with lots information about trend, buy/seller balances and about potential trend shifts. Together with the moving average and the RSI, Bollinger Bands ® make for a great foundation for a trading strategy.
See the Bollinger Bands ® in action