There is basically an indicator for every known price action move in the financial markets. Bollinger Bands invented by John Bollinger would be the focus for today. It is a technical indicator that identifies overbought and oversold conditions within markets.
I will cut down to the chase of the mathematical formulas (standard deviation) behind this tool; in order not to bore you with the figures and simplify its concept and its usefulness to you. After all, the trading platform calculates everything behind the scenes.
This technical indicator shows whether the market is trending or ranging. Thus, it can also be used to tell how volatile the market is. Volatility is the measure of the change in price of a market over a period of time.
Components and nature of the Bollinger bands.
If you look at the Bollinger bands from another angle, it is another version of the moving average indicator as it implements its concept in its structure. It consists of three main lines; an upper line, a middle line and a lower line. The middle line is the moving average which is the simple version.
As it is with most indicators, the Bollinger bands overlay price action hence it clutters the screen. In times of low volatility, this indicator contracts and in times of high volatility it expands.
As a technical indicator that shows volatility, there are two main ways in which the Bollinger bands are used. They are mostly used in ranging markets and they also indicate the end of a range where the market turns trendy.
In times of low volatility, the Bollinger bands become narrow and in times of high volatility, they become wider. In simple terms, this technical indicator is best used when the bands are narrow; this signifies that the market is trading in a range.
How to use low volatility to trade ranges with the Bollinger bands.
The upper part of the band in the ranging market is the overbought area and the lower part is the oversold area. As the terms suggest, when a market is overbought, prepare for selling pressure and when it is oversold; prepare for buying pressure.
Also, the upper and lower bands serve as dynamic support and resistance levels; if you have already seen this piece on moving averages, you already have my opinion on dynamic support and resistance levels. The idea is that the upper bands serve as resistance and the lower bands serve as support.
Ideally, financial instruments should encounter selling pressure on the upper bands and encounter buying pressure on the lower bands. Using a technical indicator like this for such a purpose could be heavily problematic.
Problematic; because just like the moving average indicator, the Bollinger band also lags, as it is with most indicators. Price moves before the Bollinger bands make their move so it would mostly get you to enter trades late; after the better money making moves have taken place.
Alternate way to trade ranges.
There are better ways to take advantage of low volatility than to follow the lead of this technical indicator. Ranging markets come in all manner of ways and using the Bollinger band to time them would certainly leave you wanting for more.
When the market is ranging, it comes in all forms of consolidative patterns like triangles, wedges, flags, tops and bottoms and a whole lot. Some of the time, consolidations are just too messy you cannot pinpoint any legitimate pattern on them. In those times, it is okay to let them go.
Using ranges in pattern forms to look for clues to trade, rather than relying on the Bollinger bands is a better option. It also goes a long way to help you filter out signals; because you would be relying on legitimate patterns only.
Also, it keeps you from trading every single touch of any of the bands which definitely leads to overtrading. With how this indicator is set up, overtrading with it will certainly lead to diminishing account balance.
How to use high volatility to trade trends with the Bollinger bands.
When the Bollinger band becomes wider, that is indicative of the end of a range. In times like this trading within the lines is not effective anymore. High volatility traders tend to take advantage of this and trade in the direction of the dominant band.
Take note that, before the bands widen for high volatility to set in, they first become way narrower than the usual low volatility’s narrow size. This is called Bollinger squeeze.
That is, when there is high buying pressure, price action sticks to the upper band which would be the dominant one. Also when there is high selling pressure, price action gets stuck to the lower band which will be the dominant one in that period.
Alternate way to take advantage of trends than to rely on this technical indicator.
When the market is not in a range, it is in a trend and it takes a breakout from the range for the market to get trendy.
Breakouts are a good alternative way to time high volatility than taking cues from widening Bollinger bands. Since the market doesn’t range forever, it does the breakout from its consolidative patterns all the time.
Going after every Bollinger squeeze in search of breakouts could also set you up to jump in trades prematurely. This is why the Bollinger band could also be noted as a leading indicator. Using breakouts instead of this indicator gives confirmation and precision.
You do not want to be trading every single bounce off the bands in ranges; and you certainly should not be involved in every trade where the band is widening. Using the price action alternatives to the Bollinger bands, give the go ahead to enter trades as and when potent signals arrive.
Honorable mention to Keltner channels.
The Keltner channel is a volatility indicator as well and it is very similar to the Bollinger bands in nature but differs a little bit in its uses. The middle line is an exponential moving average and the outer lines are average true ranges.
In an uptrend, price action stays within the upper area of the channel and in a downtrend it stays within the lower area of the band. When high bullish volatility sets in price action goes above the channel and when high bearish volatility sets in, it goes below the channel.
As we come to the end of this lesson, one important point you need to note down is that, price action and market structure thumps every indicator out there. This is because indicators rely on price action to produce its results; also the correct settings for any indicator out there is always highly subjective.