Within technical analysis, technical indicators are computational tools capable of analyzing a large amount of historical data to predict the future market performance of a financial instrument. The accessibility of technical indicators to the masses has truly revolutionized technical trading over the last two decades and this has played a considerable role in the growing popularity of the technical analysis discipline as a whole. One popular technical indicator around which many trading strategies are based is the Bollinger Bands Indicator. It was created by John Bollinger in the early 1980s to help investors determine the trend of the market over time, and has gradually become one of the most widely used technical indicators out there.
So, what exactly is the Bollinger Bands Indicator? Bollinger Bands Indicator is a volatility indicator consisting of three bands – upper, lower, and middle – that are superimposed on top of a security’s price chart. The location of a security’s price with respect to these bands and the distance of these bands with respect to one another helps determine whether a security is in overbought or oversold condition.
In this article, you will learn everything there is to learn about the Bollinger Bands and towards interpreting them. Further in the article, we will also cover some of the most prominent Bollinger Bands based trading strategies that you can incorporate into your overall trading plan. Now, without further ado, let us dive deep into these topics.
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Table of Contents
How to Read Bollinger Bands Indicator?
John Bollinger developed Bollinger Bands in the 1980s to help make sense of highly variable and chaotic financial markets. Hence, the indicator was structurally designed for easy interpretation. You can use Bollinger Bands to easily assess the price trend of any market or security and to determine the volatility of its price moves.
That being said, to leverage the Bollinger Bands indicator to its full potential, or for that matter, extract any meaningful insights out of it, you must first learn how to read and interpret it accurately. To do so, there are three basic areas that you will need to familiarize yourself with. These are –
- Construction of Bollinger Bands Indicator
- Bollinger Bands Indicator Calculations
- Interpreting Bollinger Bands Indicator Signals
In the following sections, we will discuss each of these three topics with all the necessary details that you need to know to start implementing this indicator accurately into your trading plan. Now, let us jump right into these topics.
Construction of Bollinger Bands Indicator
The structural composition of the Bollinger Bands Indicator is quite simple. The tool consists of three lines also referred to as bands, that are calculated based on the real price data of the asset.
The centerline is the SMA (simple moving average) and defines the trend of base price. The other two lines typically stand two statistical standard deviations away from this simple average line. That being said, depending on your individual trading needs and the market conditions that you are trading in, you can adjust these settings to your preferences.
To summarize, the three lines, or bands, that collectively form the Bollinger Bands Indicator are listed as follows –
- Middle Band – At the center of the tool, is the simple moving average (SMA) line that forms the indicator’s middle line. The SMA shows the overall trend of the market for the last few trading sessions. Under default settings, this line is typically calculated over 20 trading sessions, but you can adjust the sampling size to best meet your requirements.
- Upper Band – Also known as the upper resistance line, the upper band identifies the largest expected value of the asset.
- Lower Band – Contrary to the upper band, the lower band identifies the lowest expected value of an asset. It is also referred to as the lower support line.
Together, these three lines create two price range bands that rest above and below the middle line. Additionally, the bands grow and shrink with the volatility of transactions. Traders can leverage these features to gauge how the market is trending and identify potential trading opportunities. More on this will be covered in the following sections of the article.
Bollinger Bands Indicator Calculations
Today, most trading software and charting platforms come with the built-in capability to layer in the Bollinger Bands on top of the price chart. With these platforms, once you set the indicator parameters, your trading software will do the rest. Additionally, even if you need to use this indicator for tasks outside of finance, there is an extensive collection of pre-made software tools that include the Bollinger Bands and available for you to leverage. Therefore, most people will almost never have to calculate the tool themselves.
That being said, at least having a basic understanding of how the indicator is calculated will give you a better perspective on its strengths and weaknesses in trading, and allow you to better interpret its signals. Furthermore, knowing the math behind the bands will also be helpful if, at any future stage, you decide to create a new tool or modify an existing one for a new purpose.
Calculating Bollinger Bands Indicator relatively easy and not as complex as calculations for some of the other volatility indicators are. There are three steps to calculating the Bollinger Bands Indicator –
- Step-1: Calculate SMA or Middle Band
- Step-2: Calculate Standard Deviation
- Step-3: Calculate Upper and Lower Bands
Now, without any more delay, let us briefly discuss all three of these steps.
Step-1: Calculate SMA or Middle Band
In calculating Bollinger Bands, the middle band is the most central component. You must have this band calculated before you can calculate the other indicator components. Calculating this band is not too complex. Since it is a simple moving average, you just need to find the average value of all prices in your selected time period.
Under default indicator settings, this typically means averaging closing prices over the last 20 trading sessions, but you can change the calculation period to a value that best meets your individual requirements.
Additionally, in this calculation, always remember that since the middle line is a moving average, each plot point replaces the oldest value with the next price point and then recalculates the average. For example, for day 21 of a 20 period moving average line, you replace the data for day 1 with the information for day 21. This process continues until you plot the entire middle line.
Step-2: Calculate Standard Deviation
Once you have the simple moving average or the middle line, you can easily get the standard deviation. In simple terms, standard deviation is a mathematical tool for measuring variance or spread away from an average. You get it by taking the square root of the variance, which is the average of the squared distance from the average.
Step-3: Calculate Upper and Lower Bands
Finally, you draw the boundary trendlines, or the upper and the lower bands, by adding and subtracting a multiple of the standard deviation (calculated in step-2) to the SMA or the middle line (calculated in step-1). This multiple is the number of deviations you need to establish based on the market conditions that you are trading in. That being said, the standard value of 2 standard deviations is known to work well in most trading conditions. Once you plot the deviation values for every price point, you have a complete set of Bollinger Bands.
For instance, if you want the line’s k units of standard deviations:
- Upper band = SMA + ks
- Lower band = SMA – ks
Interpreting Bollinger Bands Indicator Signals
Bollinger Bands come in all shapes and sizes, but they all develop from three lines – the middle line, the upper band, and the lower band. Despite their simple construction, Bollinger Bands provide considerable insights into how the market is moving.
In determining a security’s expected future price performance using the Bollinger Bands, the key is noting how the actual price data moves around its three structural lines. In other words, important insights on the future price performance of the security can be extracted simply by looking at the position of the price with respect to the three bands.
Some of these key insights include:
- When the price of the security being analyzed is below the lower band, it indicates that a downtrend may be developing.
- When the price of the security is above the upper band, it could mean the emergence of an uptrend.
- If the price falls between the lower band and the middle line, it indicates that the price is range bound and will either bounce upwards or breakout downwards from the lower band.
- If the price falls between the upper band and the middle line, it also signals that the price is range bound and will either bounce downwards or breakout upwards from the upper band.
In addition to the above-stated insights, you can also determine if an asset is overbought or oversold using the position of its price with respect to the Bollinger Bands. Below is how you would make such determinations –
- The asset is overbought, priced high, or expensive if the price value stays near the upper band. You must note that in a strong bullish trend, an asset can remain overbought for a considerably long time.
- Contrarily, the asset is oversold, priced low, or cheap if prices remain near the lower line. Similar to what is stated for the overbought signal above, in a strong downtrend, the asset may remain oversold for a considerable duration.
While very useful, the above information only scratches the surface of what Bollinger Bands can do to inform your trading decisions. Some information is easy to see just by looking at the graph. Others require a bit more work, but they all relate to how the price action moves about the range defined by the bands.
Let us discuss some other key signals or market indications that you can extract out of the Bollinger Bands in the following subsections.
The Squeeze
The price range, or envelope, indicates the volatility of the market and is the key concept behind the bands. A tight envelope, or squeeze, shows low volatility, which may hint at future price volatility or a trend breakout. Even though false moves or moves in the other direction can occur, a squeeze signal is considered quite reliable in most trading circles.
On the other hand, the envelope expands to show high volatility. These moments may indicate that a trend is about to end. However, traders should watch for wide envelopes, which may indicate the volatility might soon decrease.
Motion Inside Envelope
The envelope also defines the expected price action. Prices may go up and down, but they will rarely leave the region defined by the Bollinger Bands. This behavior lets you make accurate decisions to increase your investment returns. For instance, you know to sell when prices hover near the top band.
Other vital insights include when trends start and end. Trends occur when the price action remains range-bound inside a channel and continues its upward or downward trajectory for prolonged periods. While not a guaranteed reflection of the market, if you see a trend forming, you may want to do further research just in case.
Breakouts
While prices usually remain inside the bands, they can move outside of them from time to time. The breakout moments identify a significant event, showing that the asset may be about to move explosively in the direction of the breakout.
However, prices can easily fall back to normal with little fanfare. Thus, you should only act if the price remains outside the envelope for long periods.
Best Indicator Settings for Bollinger Bands Indicator
As discussed in the previous section, with the mass availability of various charting platforms and software, you would hardly ever need to calculate the Bollinger Bands on your own today. All you need is to set a few parameters and then let the software do the rest.
But, what are these parameters that you need to set and how do you go about choosing the ideal setting for these parameters based on your market condition?
Let us discuss some of these questions in the following sections.
Parameter Inputs Required for Bollinger Bands Indicator
For the most part, there are just two parameters that you would ever need to input when you are setting up the Bollinger Bands Indicator for trading. These are –
- Trading Sessions or Transaction Period: The middle line or the SMA (simple moving average) line of the Bollinger Bands Indicator is calculated over a certain number of periods. Under default settings, this parameter is generally set to 20 trading sessions.
- Standard Deviations – The Bollinger Bands system defines the boundary lines as standard deviations from the SMA. Most versions of the tool defaults to two standard statistical deviations. However, you can change the parameter to something more in line with your price goals.
Ideal Settings for Bollinger Bands Input Parameters
The default indicator settings, 20 SMA, and 2 standard deviation works great in most trading conditions. However, there are certain scenarios under which you might want to adjust these settings to filter out the false signals produced by the Bollinger Bands Indicator.
Discussed below is how you would think about adjusting the indicator settings from default to something that better suits your market environment.
Trading Sessions or Transaction Period
The 20 trading sessions of the default SMA period that is used to calculate the middle line of the Bollinger Bands Indicator have proved reliable in most market conditions. However, there are certain scenarios, especially in choppy market conditions, under which you would like to adjust this setting to a more suitable number.
- In a choppy market, if you desire to trade short-term, you would like your Bollinger Bands setup to react quicker to the changes in price trends. Therefore, you would want to reduce the transaction periods to a number that is less than 20. Generally speaking, a transaction period of 10 is usually reliable for short-term trading in choppy markets.
- Contrarily, in choppy market conditions, if you want to trade long term, it is critical that you filter out the false signals generated by the Bollinger Bands setup due to outliers in the price trend. In such scenarios, you would want to smoothen the Bollinger Bands setup, and you can do so by increasing the number of trading sessions in indicator calculations. In most cases, a 50 period SMA calculation will smoothen the indicator enough to filter out any false signals for long-term trading.
Standard Deviations
Adjusting Standard Deviations, for the most part, will not be necessary. Calculating Bollinger Bands using a higher number of standard deviations will give you more reliable trading signals, but reduce the frequency of the actionable signals that get generated. On the flip side, a lower standard deviation setting will increase the frequency of trading signals that get generated, but at the expense of signal accuracy.
The default setting of 2 standard deviations generally provides a solid middle ground and is considered quite reliable. However, you can use the following directional guidelines to adjust this setting, as and when required.
- Short-term Trading: 1.5 standard deviations
- Medium-term Trading: 2 standard deviations
- Long-term Trading: 2.5 standard deviations
How Reliable are Bollinger Bands in Trading?
Similar to any other tool in technical analysis, the Bollinger Bands Indicator has its strengths and weaknesses. Fortunately, when interpreted the right way and when integrated into the right trading strategy, the indicator is incredibly reliable in most trading conditions. When the indicator says a trend is forming, chances are that a trend will in fact form, no matter how short-lived it may be. You can even use this tool to locate market tops and bottoms.
Bollinger Bands Indicator is considered so reliable because it rarely lags behind the price action. It changes itself automatically in real-time to the price. This behavior gives the tool impressive accuracy as well, assuming that you time the trades that you enter using it correctly. Furthermore, you can trust the readings from this indicator in most trading environments.
In making trade decisions using this indicator, remember the following –
- Price action will remain near the boundaries during a strong trend.
- Trends fade away as the price moves away from the boundaries.
- Actions that do not reach the boundary lines are weak.
However, all the above being said, the Bollinger Bands will not work in absolutely every trading environment. The indicator tracks the price poorly in strongly trending markets, in contrast to its near-perfect response to gentle or flat trends. The bands can tell you when a healthy market is in effect as the price actions will leave its envelope, but the indicator, by itself, cannot tell you how healthy the market is.
This failure is a byproduct of the nature of the bands. Because it expands during high volatility, the indicator can hide prolonged trends, which can continue towards the boundary without crossing it
Research has shown that Bollinger bands were more accurate when first introduced in the early ’80s. At that time, as a standalone indicator, they produced signals with a success probability as high as 0.454%. However, in more recent times, the popularity of Bollinger Bands as a stand-alone indicator and hence their profitability margin has seen some decline, except for the New Zealand and Italian Markets
Although there is evidence to show the reliability of Bollinger Bands may be waning, there is no reason to completely dismiss them when looking at long-range forecasts and determining potential trades. Additionally, in combination with other tools in technical analysis, the signals produced by the Bollinger Bands Indicator are highly accurate.
Improving Reliability of Bollinger Bands in Trading
As discussed above, despite all its strengths the Bollinger Bands Indicator is prone to certain limitations. Hence, when trading using the Bollinger Bands, it is critical that you take every possible measure to improve the reliability of the trading signals generated by the indicator.
Over the last several years, numerous experts have proposed different solutions for improving the accuracy and reliability of Bollinger Bands. While there are many ways that can be employed for the purpose, the most popular methods for improving the reliability of the Bollinger Bands Indicator are as follows –
- Using Bollinger Bands in Combination With Derived Bollinger Indicators
- Using Double Bollinger Bands Setup to Inform Trading Decisions
- Combining Bollinger Bands With Other Complementary Methods in Technical Analysis
Now, without further ado, let us discuss each of these three methods for improving the reliability of trading signals using the Bollinger Bands in the following sections.
Using Bollinger Bands in Combination With Derived Bollinger Indicators
In his book, Bollinger on Bollinger Bands, John Bollinger describes several indicators that can be derived using the Bollinger Bands. Since then, certain additional indicators have been derived using the Bollinger Bands. Such indicators, that are primarily derived using Bollinger Bands, are commonly referred to as the Derived Bollinger Indicators.
When used in combination with the Bollinger Bands Indicator, the Derived Bollinger Indicators can considerably boost the accuracy of its signals. While there are many Derived Bollinger Indicators out there, described below are the ones that most compliment the trading signals produced by the Bollinger Bands –
- Bandwidth Indicator: Investors use this indicator to monitor the width of the Bollinger Bands. When the bands become narrower, it indicates the market is range-bound or consolidating, and can perhaps be heading for a period of higher volatility.
- %B Indicator: This indicator allows the closing prices of financial instruments to be plotted and viewed in terms of percentages. The movement of the percentage within the band will indicate when market trends are beginning to change.
- BBTrend Indicator: This indicator helps investors to see both strength and direction as it relates to the market.
While no solution is perfect, pairing Bollinger Bands with other derived indicators often comes down to what you want to read from the market. You choose the pairings that best suit your needs, hoping the risks of ignoring everything else are worth it.
Using Double Bollinger Bands Setup to Inform Trading Decisions
Double Bollinger Bands Setup (DBBS) pairs the normal Single Bollinger Bands Setup with another instance of the indicator. This setup adds two more bands, which sit half the distance to the middle line from the outer bands. For example, these new bands stand at one standard deviation with the default configuration of two standard deviations.
The proponents of this setup claim that this setup will help the indicator handle the fringe cases and trends that commonly go unnoticed.
In essence, with this setup, the extra bands help highlight the following:
- Strength and duration of trends
- Profits and trade reversals
What makes DBB even more special is that you do not need a separate chart for it. You can just impose a second copy of the standard Bollinger Bands, with a standard deviation that is half of what you selected for the primary indicator, on top of your current chart. Hence, both versions of the indicator will use the same calculation methods and data samples.
Interpreting Double Bollinger Bands Setup Signals
The power of the Double Bollinger Bands Setup comes from its three separate band zones. The two extra zones give this setup the power it needs to show whether a trend has the needed momentum to continue or not. The setup can even do this with or without additional helper indicators or reference points.
- DBB Buy Zone – The top zone shows strong uptrends with high continuity chances. Price actions that remain near the top boundary favor long market positions and the closing of short ones.
- DBB Sell Zone – The lowest zone on the graph tells you when downturns are likely to continue. Prices that remain close to the bottom boundary correlate with good short positions at the expense of long ones.
- DBB Neutral Zones – The center zones act as a traditional Bollinger Bands setup. They offer no sense for trends, and mostly just indicate volatility. Actions that fall within zones tend toward the weak side of the spectrum, signaling that you may want to stay out of any major trading activities in this region.
Combining Bollinger Bands With Other Complementary Methods in Technical Analysis
Bollinger Bands beyond double provides insights into some key market performance data of a security. While the indicator may not be foolproof as a standalone indicator, it is capable of delivering very reliable trading signals when used in combination with other complementary tools.
Various tools in Technical Analysis that are known to work great in combination with the Bollinger Bands include, but are not limited to, the following –
- Japanese Candlestick Patterns
- Pivot Points
- Oscillators
Described below is how you would use each of these tools to improve the accuracy of the Bollinger Bands.
Japanese Candlestick Patterns
Japanese Candlestick Patterns are one of the most widely practiced Technical Analysis concepts in trading today. Based on numerous data points, such as the session’s opening, closing, high and low price, the candlesticks create certain well-known patterns that reveal some critical indications on the future price performance of a security.
These patterns can be bucketed into two broad categories, which along with their application in combination with the Bollinger Bands Indicator, are described as follows –
- Reversal Candlestick Patterns: These are the patterns that signal an upcoming reversal in the price trend. If you are planning a reversal trade from one of the two outer bands of the Bollinger Bands Indicator, the appearance of one or more of these reversal patterns can provide a significant boost to the reliability of the trading signal that you are basing your trade on.
- Continuation Candlestick Patterns: Contrary to the Reversal Candlestick Patterns, these patterns symbolize a potential continuation of the prevalent price trend. Therefore, their presence when you are planning to take a reversal trade using the Bollinger Bands Indicator, can serve as a sign of caution and guide you to not pursue the planned reversal trade.
Pivot Points
Pivot Points are one of the popular types of Support and Resistance Levels. They are among the very few indicators in Technical Analysis that are almost completely objective and that are exposed to very limited subjectivity. Therefore, these points provide a reliable and objective method to determine Support and Resistance points on the price chart of the security that you are trading.
In combination with the Bollinger Bands Indicator, these levels are primarily used in identifying the support and resistance level that is nearest to the lower and the upper band of the indicator respectively. Once identified, these levels form pretty reliable stop loss targets for Bollinger Bands Reversal Trades, in which you expect the price to bounce or reverse from the outer bands of the Bollinger Bands Indicator.
Oscillators
Oscillators are a type of Technical Indicators that are used to measure the momentum of a price trend. Typically, these oscillators fluctuate on a fixed scale indicating readings that help determine if an asset is in overbought or oversold condition.
In combination with the Bollinger Bands Indicator, the Oscillators help confirm the reliability of the trade signals in two ways. These two ways are –
- First, the simple overbought and oversold readings supplied by oscillators can be used to confirm the reliability of the trades that you plan using the Bollinger Bands analysis. If you are planning a buy trade and the oscillator shows an oversold reading, you will know that the reliability of the trade that you are about to take is quite high. The same principle applies, but only in reverse, with bearish or short trades as well.
- Second, the oscillator indicators help you observe divergence on the price chart of a security. Divergence, to this date, is considered one of the most reliable indications of an upcoming reversal in price trend. If your reversal trade signal from Bollinger Bands is synchronous with a divergence on the price chart, you can trade that setup with confidence as the success probability of that trade will be relatively high.
With that said, there are many different oscillator indicators that can be used in combination with the Bollinger Bands Indicator. The RSI (Relative Strength Index) Indicator and the Stochastic Oscillator are examples of two most commonly used indicators for this purpose, and Williams %R Indicator can also prove to be a great alternative for the task.
How to Trade Using Bollinger Bands Indicator?
Now that we have covered the basics, let us get straight into business and discuss how you would integrate the Bollinger Bands into a trading strategy. Like any other tool in technical analysis, the accuracy of Bollinger Bands in actual trading will depend on how you use them. Therefore, in putting this indicator to work, the trading strategy that you use it in will play a pivotal role.
Since the inception of this tool, several strategies that use the Bollinger Bands as their core concept have emerged. While your mileage may vary with them, listed below are some of the most popular and reliable trading strategies that use Bollinger Bands as a core concept –
- Trading Strategy 1: Using Double Bollinger Bands Setup
- Trading Strategy 2: Combining Relative Strength Index (RSI) with Bollinger Bands
- Trading Strategy 3: Range Trading using Bollinger Bands and Candlestick Patterns
- Trading Strategy 4: Combining Stochastics Oscillator with Bollinger Bands
- Trading Strategy 5: Multi-indicator Confluence Strategy
Now, without any more delay, let us dive deep into each of these five strategies and understand how you would determine your trade entries, stop losses, and take-profit targets using them.
Trading Strategy 1: Using Double Bollinger Bands Setup
The Double Bollinger Bands Setup is perhaps the most straightforward and intuitive trading strategy that revolves around the Bollinger Bands Indicator. Moreover, it is quickly growing in popularity, and traders at all experience levels are gradually starting to include it in their overall trading plans.
In its simplest form, outside of the standard Bollinger Bands Indicator package, you don’t need to leverage any additional tools or analysis concepts to trade using this strategy. This is because the Double Bollinger Bands Setup in itself is capable of providing most of the information that you could possibly ask for as a trader. That being said, by using this strategy in combination with other analysis concepts, such as the Pivot Points and the Candlestick Patterns, you can significantly boost the accuracy of your trades.
Finally, please remember that this strategy is primarily designed for short-term trading activities like Day Trading or Swing Trading. Even though the strategy can be used for longer-term trading as well, its accuracy is prone to considerable reduction with longer-term trading.
NOTE: In case you missed the basic chart setup that would be needed to trade using this strategy, please refer to the Double Bollinger Bands Setup in the Bollinger Bands’ reliability improvement section of the article. In that section, we have at length discussed this setup and the interpretation of the signals generated by it.
Determining Trade Entry
With the Double Bollinger Bands Setup, when it comes to determining the trade entries, the key is to focus on the price trend and the position of the price with respect to various bands.
As discussed previously, within this setup, there are three regions of significance that provide insights helpful in determining trade entries. These are –
- The Buy Zone: This is the region between the Upper Bands of the two Bollinger Band Indicators used in the setup. When the price of the security remains in this region for a considerable time, it indicates that there is a strong uptrend in the market and there is a likelihood for it to continue.
- The Sell Zone: Contrary to the Buy Zone, the Sell Zone is the region between the Lower Bands of the two Bollinger Band Indicators in the setup. If the price continuously remains in this region for quite some time, it is an indication of a strong downtrend that has a high probability of continuation.
- The Neutral Zone: Neutral Zone is the Region inside the Bollinger Bands Indicator with a lower standard deviation setting. As its name suggests, it is a zone of no bullish or bearish bias and simply indicates volatility. When the price remains in this zone for a while, it often indicates that the price is range-bound.
Now that we have revisited the three regions of significance for this setup, below is how you will make trade entry decisions leveraging them –
- When the price has remained in the buy zone for a reasonable number of trading sessions, enter a buy trade.
- Contrarily, enter a short or short-sell position if the price has remained in the sell zone for a considerable number of trading sessions.
- In the neutral zone, there is no clear indication of a price trend. Hence, it is generally regarded as a no-trade zone. That being said, if you couple the Double Bollinger Bands trading strategy with other trading methods and tools in technical analysis, this zone can provide an ideal environment for range-bound trading.
Determining Stop Loss Target
With the Double Bollinger Bands trading strategy, determining the stop loss targets is relatively easy and objective. In this strategy, the idea is that you want to hold your position until the market is trending with a strong momentum in the direction of your trade. When the price trend’s momentum falls below a level where the probability of it sustaining its directional trajectory becomes low, it is advised that you close your position using a stop loss.
Therefore, with that principle in mind, below is how you would determine the stop loss targets for your trades under this strategy –
- In the case of a long or a bullish trade, you will put your stop loss a few points below the upper band of the inner Bollinger Bands Indicator. For more aggressive trading, you can also choose to select a level that is a few points below the middle line as stop loss.
- In a similar fashion, in the case of a bearish or short trade, you will put your stop loss a few points above the lower band of the inner Bollinger Bands Indicator. For aggressive trading, you can also choose to place your stop loss a few points above the middle line of the Double Bollinger Bands setup.
In addition to the above-stated guidelines, you can always rely on external tools, such as – the Pivot Points or the Parabolic SAR, to determine the stop loss levels for your trades. But, in the majority of market conditions, you will do just fine by following just the guidelines above for stop-loss determination.
Determining Take Profit Target
When trading using the Double Bollinger Bands trading strategy alone, the fundamental principle behind setting up the stop loss and the take profit target remains the same. Therefore, as stated above, in essence, you would want to remain in trade until the momentum of the price trend is strong, and close your position for profit once the price momentum declines.
Hence, below is how you will place the take profit targets for your trades under this strategy –
- With long or bullish trades, you will close your trade for profit when the price falls below the upper band of the inner Bollinger Bands Indicator. While similar to setting stop-loss levels, you can choose to wait until the price falls below the middle line to book profits, it is not an advisable move and should only be used after careful consideration.
- Similarly, with a bearish or short trade, you will book your profits by closing your trading position when the price enters the neutral zone territory. In other words, you book your profits when the price crosses the lower band of the inner Bollinger Bands Indicator.
That being said, unlike setting stop-loss targets, when setting the take profit targets under this strategy, it is generally advised that instead of relying on purely the above-stated guidelines, you determine your profit booking points using external tools and methods. The methods of determining profit targets that most complement this strategy include – the Fibonacci Retracement and Extension Levels, Moving Average Crossovers, and the Parabolic SAR.
Trading Strategy 2: Combining Relative Strength Index (RSI) With Bollinger Bands
The Bollinger Bands Indicator is a lagging indicator. It does not predict the future. The indicator can show you what happened to the market in the past to give hints at what might come. However, its predictions get less accurate as you project further into the future.
To counter this behavior, many experts suggest combining the indicator with a leading tool. Relative Strategy Index (RSI) is one of the more popular leading indicators out there, and with the right set of complementary tools, it can do wonders for your trading.
As a momentum oscillator, RSI tracks the velocity of price movements, and its main advantage is weighing newer data over the older one. In essence, it is a 100-point scale calculated based on the inverse of the relative strength of price actions, or the ratio between the average gain and loss over a 14 session period (under default indicator settings). With this indicator, an RSI reading above the mark of 70 indicates an overbought condition, whereas an RSI reading below the mark of 30 indicates that the asset is oversold.
The strategy to sell when the asset is oversold and buy when it is overbought is not foolproof, though. Prices can stay oversold or overbought or hover around the trend lines for months without reversing. Hence, the trick to using this indicator effectively is to look for divergences.
When used in combination with the Bollinger Bands, RSI divergences are moments when the two indicators disagree on market movement or when the RSI readings disagree with the price trend. These divergence readings are indications that the market is about to experience a reversal. While not as commonly used in making the trade entry decisions under this strategy, RSI divergence provides a great way to exit trades in combination with the Bollinger Bands.
NOTE: With RSI Indicator, divergence is generally observed when the readings on the indicator disagrees with the price trend. However, in this particular trading strategy, reading misalignment between the two indicators, the RSI and the Bollinger Bands has been found to generate more reliable trading signals.
Determining Trade Entry
With this strategy, you would primarily leverage the location of price with respect to the Bollinger Bands and the overbought/oversold signals for making trade entry decisions. While RSI divergence (with respect to price, not Bollinger Bands Indicator) can also be a good signal to consider, in most market conditions simply using the overbought/oversold signals from the RSI Indicator would suffice.
That being said, in case you are interested in learning more about divergence trading with RSI, be sure to check out our article on RSI (Relative Strength Index) Indicator.
Keeping the above-described context in mind, below is how you would make a trade entry decision using this hybrid trading strategy –
- You will enter a long or buy trade when the prices are hovering around the lower Bollinger Bands, and the RSI Indicator signals an oversold condition. When an RSI is oversold, it is typically below 30. Additionally, when this setup coincides with a positive divergence reading, its reliability is considered much higher.
- Contrarily, if the prices are staying near the upper Bollinger Bands and the RSI indicates an overbought condition, you will consider entering a short or short-sell trade. When an RSI is overbought, it is typically above 70. Similar to the bearish setup described above, the presence of a negative divergence considerably boosts the reliability of this trade setup.
Determining Stop Loss Target
Just like any other trading strategy, this strategy is not foolproof. Therefore, it is critical that you judiciously choose a stop loss level to protect yourself against heavy losses.
When you enter a trade under this strategy, the hypothesis is that the price will bounce (in the case of a long or a bullish trade) or reverse (in the case of a short or a bearish trade) from the lower and the upper band areas of the Bollinger Bands. If that does not happen, it is best to exit from your trading position, as this hypothesis has pretty much failed to materialize in such scenarios.
Therefore, with this above-stated hypothesis as a foundation, below is how you would determine the stop loss targets for your trades under this strategy –
- In the case of a bullish or a long trade, put your stop loss a few points below the lower bollinger band at the time of trade entry.
- In a similar fashion, in the case of a bearish or short trade, you would place your stop loss a few points above the upper bollinger band at the time of trade entry.
Determining Take Profit Target
With this strategy, depending on your risk appetite (to lose unrealized gains) and how aggressively you want to trade, there are multiple approaches that you can leverage to determine your take profit levels.
If you are one of the conservative traders who like to lock in their profits early, the simplest way to determine your take profit targets will be using the middle line and the upper band of the Bollinger Bands Indicator. With this approach, below is how you would exit a trade to book unrealized gains –
- When in a bullish or a long trade, you would close your trade for profit once the price crosses the middle line of the Bollinger Bands Indicator or reaches its upper band. Exiting trades near the upper band of the indicator would usually work great in most trading scenarios. However, if you want to trade really conservatively, booking your profits when the price crosses the middle line of the indicator is not a bad idea.
- Similarly, in the case of a bearish or short trade, you will book your profits when the price crosses the middle line of the Bollinger Bands Indicator or reaches its lower band. The middle line of the indicator will be a good take profit target for extremely risk-averse investors. Traders with moderate risk appetite should plan to exit their positions near the lower band levels.
The above-stated framework would work great for most traders, but with this approach, you would risk losing money on the table. As discussed earlier in the article, in a strong trending market, the price may hover around the outer band region of the Bollinger Bands Indicator for an extended period of time.
Therefore, to avoid the scenarios in which you lose on a considerable portion of favorable price moves, you can take an alternative approach and leverage RSI divergence for determining take profit levels. With this approach, described below is how you would exit a position to book profits –
- In the case of a long trade, you would close your position for profit when the price hovers around the upper band but the RSI indicates a negative divergence.
- Contrarily, when in a short trade, you would exit your position to book profits when the RSI indicates a positive divergence and the price is hovering near the lower band.
Trading Strategy 3: Range Trading Using Bollinger Bands and Candlestick Patterns
If you do not have access to other Technical Indicators, or if you simply choose to not clutter the price chart with too many indicators, the Bollinger Bands Indicator can still do wonders for you. With this indicator, range trading, which revolves around the simple principle of buying low and selling high, can be really simplified. Fortunately, there are also the Candlestick Patterns to aid as a confirmation signal for your trade entries and exits here.
At its core, this strategy suggests that the prices near the upper band are expensive and that the prices near the lower band are cheap. With that principle in mind, you must trade when a price trend reversal is about to occur, within the trading range set forward by the Bollinger Bands, to get the most out of your investments.
The Candlestick Patterns give a good indication of when these reversals are likely to occur. Before the bearish reversal near the upper band of the indicator, you see candlestick patterns like Upside Down Hammer. Similarly, patterns like the Hammer emerge near the lower band when a bullish reversal is likely to occur.
Determining Trade Entry
As discussed above, with this strategy, determining your trade entry point is relatively simple and straightforward. Below is how you will enter trades when range trading with the Bollinger Bands –
- Enter a long trade when you see a reversal candlestick price pattern near the lower band of the Bollinger Bands Indicator. For more accurate entry, you can combine these signals with a positive RSI divergence, with respect to the price trend reading on the price chart.
- Similarly, you can consider entering a short trade when the price of the security is near the upper band, and a reversal candlestick pattern shows up on the price chart. A negative RSI divergence, with respect to the price trend reading, can sizably boost the accuracy of these trading signals.
Determining Stop Loss Target
Similar to some other Bollinger Bands trading strategies, you enter a trade under this strategy with an assumption that the price trend will reverse in direction once it is in the outer band region, and there are signs of a near-term reversal in the form of reversal candlestick patterns.
If that does not happen, it is best that you exit such trades and cut your losses to the minimum. With that principle in place, below is how you would determine your stop loss targets under this strategy –
- In the case of a long trade, you would put your stop loss a few points below the lower band region of the indicator at the time of trade entry.
- Similarly, in the case of a short trade, your stop loss will be put a few points above the upper band of the indicator at the time of trade entry.
In addition to the above-stated guidelines, complementary tools, such as pivot points, can also offer reliable stop-loss targets under this trading strategy.
Determining Take Profit Target
As with other Range Trading Strategies, the idea with this strategy is to sell near the top of the range and buy near its bottom. Here, the upper band of the indicator is considered to be the top of the range, and the lower band is viewed as the bottom of the range.
With this above-stated framework, below is how you would exit a trade for profit under this Range Trading Strategy that leverages the Bollinger Bands and the Candlestick Patterns –
- In the case of a long trade, you will exit your position near the upper band region of the Bollinger Bands Indicator. The appearance of a reversal candlestick pattern near the top is a strong confirmation signal that the bullish trend has run out of steam, and it is time for you to book profits by closing the trade.
- Similarly, in the case of a short trade, you will close your position near the lower band region of the Bollinger Bands. Similar to the above scenario, the emergence of a reversal candlestick pattern suggests that a change in price trend is likely and that it is time for you to exit the trade.
Trading Strategy 4: Combining Stochastic Oscillator With Bollinger Bands
The Stochastic Oscillator, also known as the Stochastic Indicator, is another leading chart indicator. Meaning, it is one of those indicators that react before the actual price action corresponding to that reaction occurs. Hence, its trading signals are very complementary to those produced by the Bollinger Bands Indicator, which for the most part is a lagging indicator.
In essence, the Stochastic Indicator compares the closing prices to their ranges over a set number of trading sessions with high levels of accuracy and understandability. It is just like the RSI (Relative Strength Index) Indicator and indicates when an asset is either overbought or oversold, but using different calculations. Therefore, in principle, you will leverage this indicator combination in a manner that is similar to what we discussed above for RSI + Bollinger Bands trading strategy.
Divergence plays a significant role in determining trading decisions with this trading strategy as well. Hence, observing when the Stochastic Oscillators’ reading diverges from the signals generated by the Bollinger Bands or the price trend is essential to successfully trade using this strategy as well.
Determining Trade Entry
With this strategy, at a high level, there are two different paths that you can take to determine your trade entry position.
The first and simpler path is to leverage the overbought and the oversold readings generated by the Stochastics Oscillator in combination with the price’s location with respect to the Bollinger Bands. Under this path, described below is how you would determine the entry points for your trades –
- Enter a bullish or a long trade when the price of the security hovers around the lower band of the Bollinger Bands Indicator, and the Stochastic Oscillator indicates an oversold condition.
- Similarly, consider entering a bearish or a short trade when an overbought reading on the Stochastic Oscillator is synchronous with the price hovering near the upper band of the Bollinger Bands Indicator.
The alternative and the slightly more complex approach to determining trade setups under this strategy leverages divergence. Described below is how you would enter a trade under this approach –
- To determine entry for a bullish or long trade, you would look for opportunities where the price is hovering around the lower band of the Bollinger Bands Indicator and the Stochastic Oscillator indicates positive divergence.
- Similarly, when the Stochastics Oscillator shows negative divergence and the price is fluctuating near the upper band region, you would consider entering a bearish or a short trade.
Determining Stop Loss Target
The hypothesis based on which you enter a trade position under this strategy is that the price will experience a reversal in the near term and not continue on its existing trajectory. When that does not happen, you must minimize your losses by exiting the trade.
Hence, below is how you will determine the ideal levels on the price chart for placing your stop losses under this strategy –
- For bullish or long trades, place your stop loss a few points below the lower band of the Bollinger Bands Indicator.
- Similarly, for bearish or short trades, your stop loss will be put a few points above the upper band of the Bollinger Bands Indicator.
In addition to that, as also mentioned for several other trading strategies, you can always rely on other complementary tools, such as the Pivot Points or the Parabolic SAR, to determine the stop loss levels for your trades.
Determining Take Profit Target
Similar to what we discussed for the RSI + Bollinger Bands trading strategy, there are two sets of options for determining take profit targets using this indicator duo as well.
For more conservative or risk-averse trading, you can take the following approach to set the take profit targets for your trades –
- For bullish or long trades, close your trade for profit once the price crosses the middle line of the Bollinger Bands Indicator or approaches its upper band. Generally speaking, the upper band serves as a reasonable take profit target in most market situations, but if you are completely risk-averse you can choose to exit your positions the moment the price crosses the middle line.
- Similarly, in the case of bearish or short trades, you will set your take profit targets at the middle line or near the lower band of the Bollinger Bands Indicator. The middle line of the indicator can oftentimes be considered too conservative for exiting trades, but it proves to be a reasonable target for risk-averse trading.
Alternatively, you can also leverage the divergence and overbought/oversold readings from the Stochastic Oscillator to determine your take profit levels. With this approach, below is how you would decide on exiting your positions to lock unrealized gains –
- With the long or bullish trades, you would exit your position when the price hovers around the upper Bollinger Band and the Stochastic Oscillator indicates negative divergence or an overbought reading.
- In a similar fashion, with short or bearish trades, you would consider closing your position for profit when the Stochastic Oscillator indicates an oversold reading or positive divergence and the price of the security fluctuates around the upper Bollinger Band.
Even though the above two approaches for determining take profit targets would work great for most trades, if you desire to exit your positions at the most profitable price points, you must consider incorporating other tools such as the Fibonacci Retracement and Extension Levels into your overall trading strategy.
Trading Strategy 5: Multi-indicator Confluence Strategy
In addition to all the above-stated trading strategies, one highly reliable approach to trade using the Bollinger Bands Indicator is to use portions of all the above-stated strategies at once. The accuracy of your trading decisions gets a significant boost when you take a multi-indicator confluence approach with either a single or double Bollinger Bands setup.
Such an approach is especially helpful when you are trading on a very small timeframe and need to quickly make trading decisions to profit from the short term market moves. This is because on small timeframes the frequency at which false indicator signals get generated is usually higher, thus warranting the need for a method to filter out the false signals generated by any one of the previously covered methods.
All the above being said, one obvious downside of trading the Multi-indicator Confluence Strategy is that with this approach the number of trade triggers that you get is considerably reduced. Therefore, there is always a risk of you missing out on numerous good trading opportunities by using too many indicators to confirm signals. Hence, it is important that you keep it balanced and don’t overkill this strategy.
Generally speaking, using a single Bollinger Bands Indicator setup in combination with the RSI, the Stochastic Oscillator and the Candlestick Patterns provides the right level of signal assurance without the overkill in this trading approach. The confluence of the RSI and the Stochastic Oscillator ensures that the divergence and the overbought/oversold readings that you get are accurate, and the candlestick patterns provide the additional boost to your trade accuracy.
Now, without further ado, let us discuss how you would determine the trade entries, stop loss levels, and the take profit levels under this trading strategy.
Determining Trade Entry
As discussed above, with this strategy, you would enter a trade when there is a confluence of trading signals from all the three indicators/tools that are clubbed together in the Bollinger Bands setup. Hence, described below is how you would enter a trading position under the Multi-indicator Confluence Trading Strategy –
- To enter a buy or a bullish trade, you would wait for a confluence of three trading conditions. These conditions are –
- First, the price is hovering around the lower band of the Bollinger Bands Indicator.
- Second, the RSI and the Stochastic Oscillator both indicate either an oversold condition or signs of positive divergence.
- Third, a reversal candlestick pattern shows up on the price chart of the security that you plan to buy.
- In a similar fashion, to enter a sell or a short-sell trade, the three conditions that are listed below must hold true. These conditions are –
- First, the price of the security must be fluctuating around the upper band of the Bollinger Bands Indicator.
- Second, there should be signs of either an overbought condition or negative divergence on the scale of both, the RSI and the Stochastics Oscillator
- Third, there must be a reversal candlestick pattern formed on the price chart before you enter the market with a short trade.
Determining Stop Loss Target
With this strategy, the stop loss target is determined similar to many other trading strategies covered in this article before. Below is how you would decide on a stop loss when trading with this strategy –
- In the case of a long or a buy trade, you would put your stop loss just a few points above the upper band of the Bollinger Bands Indicator.
- Whereas, when taking a short or a short-sell trade, you would choose a stop loss at a point that is a few points below the lower band of the Bollinger Bands Indicator.
Determining Take Profit Target
Just as is the case with many other trading strategies discussed above, there are two approaches to exiting trades for profit under this strategy.
In a conservative and risk-averse approach, you will leverage the position of the price with respect to the middle and the upper bands of the Bollinger Bands Indicator to inform your trade exit decision. With this approach, below is how you would exit a trade for profit.
- In the event of a bullish or a buy trade, you would close your trade for profit when the price either crosses the middle line or approaches the upper band of the Bollinger Bands Indicator. The later target would serve you well in most scenarios, but you should close your trade as soon as the price crosses the middle line if you intend to reduce the risk of losing unrealized gains to the minimum.
- Similarly, in the event of a bearish sell trade, you would put your take profit target at either the middle line or a few points above the lower band of the Bollinger Bands Indicator. The middle line is a more risk-averse and conservative target than exiting the trade near the lower band of the Bollinger Bands Indicator.
In case you are not fully opposed to assuming more risk for the potential to lock even bigger profits, described below is how you can choose your trade exit targets –
- When in a bullish or a long trade, you would close your position for profit when the price is hovering near the upper bollinger band, and either RSI or the Stochastics Oscillator indicates an overbought condition.
- Similarly, in the case of bearish or short trades, you will book your unrealized profits when the price is near the lower band of the Bollinger Bands Indicator, and either the RSI or the Stochastics Oscillator indicates an oversold condition.
Advantages and Limitations of Trading Bollinger Bands
John Bollinger never intended his invention to work alone; Bollinger Bands show price volatility, and nothing more. While you can gain other insights from them, they are best used in combination with other indicators to create a complete trading technical analysis package.
Additionally, to effectively incorporate the Bollinger Bands into your trading strategy, it is critical that you understand their strengths and weaknesses. Therefore, in the following sections, let us review several important advantages and limitations of trading using the Bollinger Bands Indicator.
Advantages of Trading Bollinger Bands Indicator
Listed below are the key advantages of trading with the Bollinger Bands Indicator –
- Bollinger Bands are very accurate and reliable when it comes to measuring the volatility in the price trend of an asset.
- The indicator tracks the current market movements and provides trading signals in real-time.
- On relative terms, the Bollinger Bands are easy to use and interpret.
- It is considerably easy to integrate the Bollinger Bands with other trading strategies.
Limitations of Trading Bollinger Bands Indicator
Listed below are the key limitations of trading with the Bollinger Bands Indicator –
- The signal accuracy of the indicator takes a serious hit during strong trends.
- Just as with any other technical indicators, the Bollinger Bands are based on historical data, and the historical performance of an asset is not a conclusive indication of its future performance.
- If the indicator settings are not carefully chosen to meet the needs of the market that you are trading in, the indicator can easily dilute new information and generate signals based on outdated data.
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Conclusion
Bollinger Bands offer an excellent snapshot of how a market will move. While not a standalone system, it is good enough for most trading situations where you need a quick understanding of the market.
You can also use this indicator in any and all types of markets. With the right insight, you can use the Bollinger Bands for more than just the market volatility. While best paired with other indicators, you can get a lot of information from Bollinger Bands if you keep your eye out for specific signals in the price movement.
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