I hope you’re enjoying our series of Technical Analysis where I explain some of the most widely used Indicators in a simple fashion to help you understand how they work and help you improve your technical analysis skills.
This is the 4th post of the series and today I am going to explain Bollinger Bands. To read all previous posts in this series click here.
Bollinger Bands is one of the famous indicators of the trading world used by many pro traders. It was developed by John Bollinger in 1980’s.
What does Bollinger Bands Indicate?
Bollinger bands will help you to get an idea about the volatility of the market. It also indicates when an asset is overbought or oversold.
They consist of three bands, namely the middle band, upper band, and lower band. The middle band represents the simple moving average.
The distance of the bands from each other represents the volatility of the market.
If the price touches the upper band, then the asset is considered overbought, while if the price is touching the lower band, then the asset is considered to be oversold.
Usually, the price stays between the bands, but on rare occasions, it represents extreme market conditions if it is above or below the two extreme bands.
When we talk about Bollinger Bands, then there is an important concept of the squeeze.
It lays down the theory that if the bands are close to each other, it represents that market is about to become highly volatile, while if the bands are far away from each other, it represents a less volatile market in near future.
How to read Bollinger Bands?
You can match all these points with the chart shown above to understand it better.
- When bands are contracting, there are chances of sharp price changes.
- When the price line surpasses the bands’ range, that is a strong signal of continuation of the current trend.
- When new highs and lows are made outside the bands followed by highs and lows made inside the bands, it shows an imminent trend reversal.
- If a move originating in one band tends to replicate on the other band too, it is useful in deciding future price targets.
- If the price pulls back within the uptrends, and it stays above the middle band and moves back to the upper band, that indicates a lot of strength.
- In a strong trend, prices will move along the bottom line or top line. But if the price fails to touch or move along the upper and lower bands, it indicates the trend is losing momentum.
- M-patterns is one of the signals created by Arthur Merrill as an extension to Bollinger Bands to identify M-Tops, which shows signs of confirmation when prices are making new highs.
- W-Bottoms, again Arthur Merrill’s work to identify W-Bottoms to determine the strength when prices are making new lows.
Limitations of Bollinger Bands
- Bollinger Band is a lagging indicator as it is based on a simple moving average which means it reacts to price movements and doesn’t predict the price movements.
- Standard settings will not work on every chart, traders will have to adjust the settings for different assets.
While Bollinger Bands is a very good indicator to catch momentum and strength of a trend, it should not be used as a single indicator.
Always, pair it with at least one other indicator of your choice. My personal favourite to pair it with is RSI (Relative Strength Index).
Bollinger Bands when paired with RSI can help you catch tops and bottoms. Whenever, the price fails to cross over the upper or lower band as the trend becomes weak, it is usually accompanied by a divergence on RSI.
Also, the 50% mark on RSI coupled with the middle line of Bollinger bands can give you double confirmation of the trend strength.
I hope you enjoyed this post and got an idea of how to use Bollinger Bands. For any other query, you can let me know in the comment section below.
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