Developed by John Bollinger in the 1980s, Bollinger Bands (BBs) are a popular public domain technical tool for active futures traders. No matter your trading style or preferred market, having Bollinger Bands explained within a strategic framework can be a positive first step toward profitability.
What Are Bollinger Bands?
Bollinger Bands are a technical indicator used to determine the evolving levels of pricing volatility present in the market of a security. They are applied as an overlay, commonly plotted side by side with price itself via line, OHLC, or candlestick charting techniques. The visual component of BBs makes them an ideal tool for recognizing market states effortlessly, regardless of how volatile or quiet price action may be.
Bollinger Bands have three basic elements:
- Period: Periodicity refers to the “look back” sample by which BB calculations are performed. A period of 20 is a baseline setting commonly used by active traders. It may be implemented on pricing data of any timeframe, from intraday to yearly increments.
- Standard deviation: Standard deviation measures the degree of pricing variations from an established mean value. A standard deviation setting of 2 is frequently used in BB derivations.
- Midpoint: The midpoint of a set of BBs is essentially a moving average. It’s calculated according to the periodicity, as well as the high, low, mid, or median of the chart’s pricing bars.
Perhaps the most attractive part of Bollinger Bands is that they’re relatively easy to configure and use. Their functionality is included within the analytical suite of most software trading platforms and is readily applicable regardless of chart type or duration. All you need to do is select a desired period, standard deviation, and moving average type. After you configure these three inputs, the BBs are ready for action.
Bollinger Bands Explained: Interpretations and Applications
By nature, Bollinger Bands quantify and illustrate pricing volatility. This is accomplished by plotting three lines known as bands as an overlay on a pricing chart. Outer extremes represent the positive and negative standard deviation in relation to price, while a center line acts as the midpoint or mean value. Although BBs have a straightforward appearance, the question remains: What do they mean?
Addressing the spatial relationship between outer bands is the key to understanding the concept of Bollinger Bands. In essence, two primary themes are present in almost every BB strategic application:
- Compression: A compressed market is one that’s trading in a condensed periodic range. This is indicated by the distance between outer bands decreasing or “tightening.”
- Trend: Trending markets are easily discerned by using BBs. As a market extends directionally, the distance between outer bands begins increasing or “widening.”
Once again, the beauty of this technical tool is how user friendly it is. If the outer bands are close together, the market is compressed. This is indicative of slow price action and limited participation. If far apart, the market is trending directionally, driven by active trading conditions. Simple as that!
As with a majority of technical tools, Bollinger Bands are best used in conjunction with additional indicators to form trading decisions. No single technical study or analytical device is infallible ― the more evidence a trader bases decisions on, the better any executed trade is likely to perform.
That being said, here are two unique ways traders can use BBs within the parameters of a comprehensive trading plan:
- Identify breakouts: In times of compressed trading ranges and tightened BBs, a breakout is often brewing. Entering a market after price has penetrated either of the outer bands can be an effective way of getting in early on a soon-to-be trending product.
- Rotational trading: Strategies for range bound markets can be executed via the functionality of BBs. Buying or selling in opposition of price action from outer bands back toward the midpoint is one example of a “regression to the mean” methodology.
Identifying rock-solid trading opportunities in real-time is no easy task. However, Bollinger Bands can help streamline the process and contribute to the successful execution of breakout and rotational trading strategies.
Getting Started with Technical Analysis
If you have traded any asset class — whether it’s stocks, currencies, or futures — then you know the value of technical analysis. Although there’s no holy grail indicator, many traders rely on BBs as a regular part of their approach to the markets.
For more information on the study of price action, or to have Bollinger Bands explained in greater detail, check out dt’s Technical Analysis Learning Center. From candlestick charting to volume and open interest, this robust educational suite can take your analytical game to the next level.