One of the most popular indicators across all markets is the Bollinger Bands, developed by John Bollinger, a well-known trader in traditional markets.
The Bollinger band consists of three lines. Traders are already quite familiar with one of these, the 20-period simple moving average. The exterior lines that envelope the indicator are standard deviation bands, which by default represent two standard deviations above and below the 20 period SMA.
Standard Deviation Bands
Before deciphering the indicator, we must first understand the idea behind standard deviation bands. Standard deviation is the measure of variation or dispersion that is found within a set of values. A low standard deviation indicates that the values tend to be close to the set’s mean, while a high standard deviation indicates that the values are spread out over a wider range.
In a typical statistical data set, according to the Empirical Rule, the values within one standard deviation of the mean account for about 68% of the set, and values within two standard deviations account for about 95%.
How to use the Bollinger Bands?
Once again, in its default form, the Bollinger Bands are set to 2 SD, but if you increase or decrease this you can set them to capture more or less of the target values. You can also change the moving average setting as well.
Though the Bollinger Bands are used in many trading systems, traders most commonly use is to spot mean reversion opportunities and changes in volatility.
Use the Bollinger Bands to spot mean reversion trading
With mean reversion trading, the Bollinger bands are best used when price is exhibiting ranging behavior. The idea behind the strategy is that price tends to return to the average over time. With this strategy, the upper and lower bands act as dynamic support and resistance levels. When price is ranging and moves either to the top band or the lower band, we can look for signs that the move is either exhausting or being absorbed, and therefore likely to return to the average (or what are considered “norms). This is best applied when the bands are not expanding and instead remain more stable.
There are plenty of strategies that traders can experiment with using this method:
(A)-One might be to look for three drives into the highs or lows to look for trading opportunities back to the mean.
(B)-Another might be to play the successful crosses and retests of the mean with the intention of taking a move back to an extreme.
The main principle behind using the bands is that over time things tend to return to the average. In ranging conditions, price is being accepted within a range of values. Good risk-reward opportunities can arise when price approaches an extreme of what these normal values are, as long as we operate under the assumption that the range is to continue and conditions are to persist the way they have been. This type of system can be sharpened by a trader that is adept with price action.
Use the Bollinger Bands to spot changes in volatility
One other popular use for the Bollinger Bands is to spot changes in volatility. Specifically, the type of compression that occurs before breakouts or continuation. In markets, compression leads to expansion and then back to compression again. One thing that we can look for to potentially time or spot periods that precede breakouts, are areas where the Bollinger Bands begin to compress or Bottleneck.
Bollinger Band Squeeze
Often, when a market is trending, the Bollinger Bands will remain expanded, and the consolidations that occur during the trends will lead back to compressions. Spotting the bottlenecking can allow a trader to position themselves properly in the tightest area, offering a superior location to define risk and place a stop. This can be especially useful for breakout traders. Identifying this behavior can also allow a trader to prepare themselves for a volatility squeeze if they are already in a position.
The best thing to do with this indicator, like all other indicators, is experimenting with it yourself. Try it across both the lower and the higher timeframes, with both default and modified settings. Generally speaking, the higher the timeframe you are in, the stronger the signals tend to be.
By Ryan Scott (@CanteringClark)
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