Trading assets in an unpredictable market is risky business. The risk is what makes stock trading a constant challenge for traders. This is why stock traders are always on the lookout for tools that can help them predict the oncoming changes in the market. While such tools don’t offer a picture-perfect prediction of the market behavior, they still help narrow down the risk of trading. Among many others, Bollinger Bands are one such tool.
In this comprehensive guide, we will learn about what Bollinger Bands are, their background, their purpose, their structure and much more. So, without further delay, let’s get started!
Bollinger Bands: An Introduction
Bollinger Bands are handy tools that traders use to measure the market volatility of a financial commodity or tradable asset. Specifically, they are two-dimensional charts that offer statistics like prices and volatility of the asset of trade in a formulaic fashion.
Bollinger Bands employ the measure of standard deviation, used widely in statistics, to determine the position of likely supportive and resistant bands.
The credit of introducing the world to Bollinger Bands goes to John A. Bollinger, a renowned author and technical analyst of the financial markets. He started working on these Bollinger Bands in the early 1980s.
Back then, traders were already applying bands of fixed width while trading. So, Bolliger decided to use standard deviation to ensure that trading bands became adaptive. Therefore, in simple terms, Bollinger Bands are adaptations of the already applicable Keltner Bands and other similar channels.
When the Financial News Network introduced them, these bands did not have a name. Upon being prompted by the interviewer, Bollinger decided to call them after himself.
Aside from measuring the market volatility of stock trading prices, these bands also provide other useful information. That’s right. Bollinger Bands indicate the continuation or reversal of market trends. Also, they identify the periods when the market consolidates, or even better, periods of major upcoming volatility breakouts. Further, Bollinger bands are extremely helpful in predicting the possibility of market tops and bottoms and identifying potential price targets.
When it comes to the architecture of Bollinger Bands, there are three basic constituents. These are three bands that are integral to the entire structure. These three bands move around a central band that goes by the name “Simple Moving Average” or “SMA.” The SMA adopts 20 as a default value. Most of the time, the price varies within the boundaries of the Lower Band and the Upper Band.
Additionally, the Lower Band is two standard deviations below SMA, while the Upper Band is two standard deviations above it.
In their most basic form, the channels of the Bollinger Bands represent top and bottom. Simply put, they represent various levels of high and low market prices of a commodity. Here are three significant points about the interpretation of these bands:
- The Upper Band is indicative of a high (expensive) level according to the statistics.
- The Lower Band represents a level of a statistically low price.
- The bandwidth of Bollinger Bands are directly related to the volatility in the market.
In addition, the standard deviation varies in accordance with the width of price ranges. Its value is high when the price ranges are wide. Similarly, it has a low value with narrow price ranges. Therefore, in a highly volatile market, Bollinger Bands are wide. In a similar way, these bands are narrow for low volatility in the markets.
When using Bollinger Bands for trading, the behavior of the price (price action) near the edges of the band is of particular interest. For technically analytical trading, making trade close to the outer bands gives the trader an idea of resistance or support bands. However, this alone does not suffice to ensure successful trade.
The best part about Bollinger Bands is that they are applicable to all sorts of markets. For starters, one should stick to a 20 day band circulation period and stray from it only under compelling circumstances. The trader needs to increase the number of employed standard deviations on the basis of the number of periods in use.
Some Trading Tips
Trading using Bollinger Bands does not work out the same for all traders and varies with experience. Here are some trading tips that beginners may find helpful:
- Bollinger Bands give an indication of high and low prices. Traders can use this to compare price and indicator actions to make informed buy/sell decisions.
- You can use key elements like volume, momentum, sentiment, inter-market data, and more to derive the right indicators.
- You should not employ the use of volatility and trend for the confirmation of the action of price.
- While using indicators, you should make sure they are related to one another.
- You should be aware of the possibility that price can flutuate between the upper and lower Bollinger Bands, respectively.
- You should also be aware that the closes outside of the Bollinger Bands are continuations and not reversal signals.
- The default value for shifting the average line is 20 periods. It is the basis of a great many standard deviation calculations.
- If you are lengthening the average, it should also increase the number of standard deviations simultaneously. Similarly, if you shortening the average, it should decrease the number of standard deviations.
- You should not make any statistical assumptions on the basis of the calculation of standard deviation.
- You can normalize indicators by eradicating fixed thresholds.
That’s all for this guide. We hope you enjoyed it and found it helpful and worthy of your time.
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