These days, there are various indicators available for trading in the Forex market, and it seems that every few months a new trading indicator appears on the scene. However, often these new indicators are merely different versions of the classic ones. Today, we will discuss one of the most powerful trading indicators that has proven its worth over time: the Bollinger Bands. We will discuss the fundamental elements of this indicator and introduce you to several profitable trading strategies using Bollinger Bands.
What are Bollinger Bands?
Bollinger Bands are a technical analysis tool used to assess price volatility and identify buy and sell conditions in financial markets, particularly in the Forex market. This indicator was developed by John Bollinger in the 1980s and consists of three lines:
1. Middle Line (Simple Moving Average): This line is typically the 20-day simple moving average of closing prices and indicates the overall price trend.
2. Upper Band: This band is usually positioned two standard deviations above the middle line and indicates high price volatility levels.
3. Lower Band: This band is typically placed two standard deviations below the middle line and indicates low price volatility levels.
Bollinger Bands MT5 help us identify overbought conditions (when the price approaches the upper band) and oversold conditions (when the price approaches the lower band). Additionally, these bands can provide signals for market entry and exit and help monitor price volatility. Overall, Bollinger Bands MT5 are a useful tool for technical analysis and decision-making in trading. Traders can effectively utilize this feature in the MT5 platform to enhance their trading strategies.
"Bollinger Bands were designed to..."
Bollinger Bands were designed by the famous technical trader, John Bollinger, and are named after him. This indicator greatly aids investors in accurately identifying the overbought and oversold points of an asset.
Analysis of Bollinger Bands in Forex
The best description of Bollinger Bands is that they are a volatility indicator on the chart. As previously mentioned, this indicator consists of upper and lower bands that react to changes in volatility. These two bands are positioned above and below the price movements. When the volatility of a specific currency pair is high, the distance between the two bands will increase, and when the volatility of a particular currency pair is low, the two bands will contract. This indicator includes a 20-period simple moving average, which can be used to set entry and exit points for trades.
Traders often utilize Bollinger Bands MT5 settings to analyze market conditions effectively. By monitoring the movements of the MQL5 Bollinger Band, traders can better identify key trading opportunities based on volatility changes.
Calculating Bollinger Bands
The first step in calculating Bollinger Bands is to compute the simple moving average (SMA) for the target stock price. Typically, a 20-day simple moving average is used. The 20-day SMA is calculated by averaging the closing prices from the most recent data up to 20 days prior. For the twenty-first day, the first day's data is dropped, and the twenty-first day’s data is added, and the average is recalculated. This process continues in the same manner until the end. Then, the standard deviation of the stock price is obtained. The standard deviation is a series of mathematical calculations of the variance around the mean, which is applicable in statistics, economics, accounting, and finance.
For a given data set, the standard deviation measures the spread of the numbers from a mean value. The standard deviation is calculated from the square root of the variance. Variance, on the other hand, is determined by the average of the squared differences of the data from the mean. (In simpler terms, you first subtract the mean from the data points, then square the obtained numbers, and finally calculate the average of those squared numbers). Next, you multiply the standard deviation by 2 and add and subtract both resulting values from the SMA values. The sum of the obtained numbers gives the upper band, and the difference provides the lower band.
The formula for Bollinger Bands is as follows:
Pivot Point (TP) = (High Price + Low Price + Closing Price) / 3
BOLU = Upper Bollinger Band
BOLD = Lower Bollinger Band
MA = Moving Average
n = Number of days (typically 20 days)
m = Number of standard deviations (typically 2)
σ[TP, n] = Standard deviation over the past n periods from the Pivot Point
What Do Bollinger Bands Indicate to Us?
Many traders believe that as prices approach the upper band, we get closer to overbought conditions, while conversely, as prices approach the lower band, we approach oversold conditions. John Bollinger has a set of 22 rules that should be followed when using Bollinger Bands.
In the chart below, you can see the Bollinger Bands with a 20-day simple moving average. Since standard deviation measures volatility, when markets become unstable, the bands expand, and during quieter periods, the bands contract.
Although this indicator is primarily a volatility indicator, Bollinger Bands are quite useful in identifying support and resistance areas. This indicator consists of three lines, each of which can indicate support and resistance; however, the Bollinger Bands, composed of the upper and lower bands, are usually more effective for this purpose than the middle line.
Multiple signals can be generated through Bollinger Bands. These signals respond to various price behaviors on the chart. Now, let's examine each of these signals and discuss their potential.
The Concept of Bollinger Band Squeeze
The squeeze of Bollinger Bands is the core concept of this indicator. It refers to the bands coming closer together and converging around the moving average. A squeeze in the bands signifies a period of low volatility in trading, which traders interpret as a potential signal for a forthcoming period of high volatility, creating good trading opportunities for them. Conversely, as the bands widen, it likely indicates a decrease in volatility, and traders may be more inclined to exit their positions. However, these conditions are not trading signals. The bands do not indicate when these changes will occur or in which direction the price may move. The image below displays a classic Bollinger Band squeeze.
When the Price Touches the Lower Band
This is a common signal of Bollinger Bands indicating that the price is relatively low or has entered the oversold region from a volatility perspective. As a result, a rebound may occur, creating a buying opportunity. You can consider this line as a hidden support level.
However, if the price immediately starts to drop after touching the lower band and the distance between the two bands continues to widen, caution is warranted before entering a buy position. When the bands are expanding and we observe strong momentum in the price below the lower band, it indicates that a bearish trend is likely to persist in the market.
When the Price Touches the Upper Band
Here, the same scenario as before is occurring, but in the opposite direction. Based on observing significant volatility, we consider the upper band as a hidden resistance level. However, if the bands expand and candles close above the upper band consistently, it is expected that the upward trend will continue.
Bollinger Band Breakouts
Approximately 90% of price fluctuations occur between the two bands. Any breakout (whether above or below the bands) signifies a significant event. However, it's important to note that breakouts are not trading signals. Many traders make the mistake of assuming that touching or exceeding a band provides a signal to buy or sell, while these breakouts do not offer clues about the future direction or magnitude of price movement.
However, a breakout of the Bollinger Bands' moving average is considered a confirmation signal that typically happens after price interacts with the bands. If the price pulls back from above the band and breaks the 20-period simple moving average downward, we receive a strong sell signal. Conversely, if the price bounces off the lower band and breaks the average upward, we will have a strong buy signal.
Thus, the breakout of the 20-period simple moving average (SMA) can be used to determine exit points after entering trades based on Bollinger Bands.
Bollinger Band Strategy and Candlestick Patterns
A reliable method for trading using Bollinger Bands is to combine Bollinger Band analysis with candlestick pattern analysis. Essentially, you can enter a buy trade after the price touches the lower Bollinger Band and a candlestick closes with a reversal pattern. Conversely, you can open a sell trade after the price of a Forex pair touches the upper band and a reversal candlestick forms.
To implement this, you should place a stop-loss order above or below (depending on whether it's a buy or sell order) the reversal candlestick. I prefer to close half of the trades when the price reaches the Bollinger moving average. The reason is that candlestick patterns often lead to moderate price changes rather than significant movements, typically resulting in shorter price actions. We can leave the other half of the trades open for potential profit and any long-term movement. In this case, if the price continues in our desired direction, we can use the breakout of the Bollinger Bands' moving average as an exit signal. However, remember, if you see confirmation of another reversal pattern before this occurs, there's no need to wait for the simple moving average (SMA) breakout, and instead, you should close the trade as soon as possible.
Breakout Strategy with Bollinger Bands
In this trading strategy, we will focus on conditions where the price moves beyond the upper or lower Bollinger Band. Simultaneously, the bands should be widening, indicating increased market volatility. Additionally, we consider the volume indicator to ensure we only enter a trade when high volume is present or when volume is increasing in the direction of the trend.
If all of these conditions are met, you can enter a trade that aligns with the breakout. This approach allows you to capitalize on the rapid price movement caused by high trading volume and increased volatility. You should remain in these trades until the price breaks the 20-period Bollinger Bands' moving average in the opposite direction.
MACD and Bollinger Bands Integration Strategy
Traders can effectively use Bollinger Bands in combination with the MACD indicator. Bollinger Bands allow traders to observe the cyclical nature of volatility, while MACD serves as an effective trend-following indicator.
Utilizing these two indicators enables traders to gain a higher probability of identifying the strength and direction of the trend. Traders can use MACD to assess whether the trend is increasing or decreasing and employ Bollinger Bands as entry triggers and trade confirmations.
The combination of these two indicators can be executed in various ways, but two common methods are using breakouts and following trends.
To trade based on breakouts, you should follow these steps:
1. Use the MACD indicator to identify a trending market.
2. Look for divergence in the MACD histogram. Divergence can signal a potential breakout.
3. Watch for a breakout from the 20-period moving average (in Bollinger Bands) or a trend line.
4. Confirm the breakout using Bollinger Bands (the expansion of the bands indicates increased volatility) and look for momentum increases in the MACD chart (an increasing histogram indicates rising momentum).
Traders may look for a potential breakout in a strong downward trend by observing divergences in the MACD histogram.
A breakout above the 20-period moving average (the central line of the Bollinger Bands) after spotting a divergence signals a buying opportunity. Additionally, a break above the descending trendline serves as another confirmation for a trend reversal.
As the Bollinger Bands expand, it indicates increasing volatility, which is further supported by the rising MACD, showing a strengthening momentum. Traders can set their stop-loss below the Bollinger Bands or beneath the descending trendline. Take-profit levels can be positioned at resistance levels to ensure an adequate risk-to-reward ratio. Since a breakout may lead to a trend change, using a trailing stop-loss is advisable.
To trade based on the trend, follow these steps:
* Identify a trending market using the MACD indicator.
* Use the price bounce off the 20-period moving average as an entry point aligned with the trend.
* Pay attention to the momentum in the MACD for confirmation.
* Utilize the lower Bollinger Band (or the upper band in a bullish trend) as a stop-loss.
Implementing a Bollinger Bands trend following strategy indicates a continuation of the trend, given that both lines of the MACD are in the positive range. Therefore, traders should be prepared for a buying opportunity.
After an initial upward momentum bounce, the momentum diminishes. Even though the MACD line crosses above the signal line, this movement occurs with low volume, leading to short-term consolidation rather than a reversal. Consequently, the bullish trend is reinforced, and the price is expected to bounce from the 20-period moving average. Traders can seek entry points when the price touches the 20-period moving average, with stop-loss levels at the lower Bollinger Band and take-profit targets set at significant support or resistance levels.
Two Bollinger Bands Strategy
In the Two Bollinger Bands strategy, as the name suggests, two Bollinger Bands are used to identify entry and exit points. The goal of this strategy is to enter a buy trade when the price is above one standard deviation and to enter a sell trade when the price is below one standard deviation. This strategy can be implemented as follows:
1. Place a Bollinger Bands indicator on the chart with a 20-period moving average and a standard deviation of 2.
2. Place another Bollinger Bands indicator on the chart with a 20-period moving average but this time with a standard deviation of 1.
3. Statistically, 95% of candles should be within two standard deviations, meaning that any movement outside this range could be a buy or sell signal.
In this strategy, there are three different zones:
Buy Zone: This area, marked in light blue in the charts below, is the space between two standard deviations and above the 20-period moving average. When buyers have the dominant power, the price reaches this zone.
Neutral Zone:This zone, marked in purple, is the overlapping area between the two Bollinger Bands. In this area, no specific bias can be considered.
Sell Zone: This area, also marked in light blue, is located below the 20-period moving average. When sellers have the dominant power, the price reaches this zone.
There are two main methods for trading based on the Two Bollinger Bands strategy, which are discussed as follows:
Breakout Method
This method can be applied when the price breaks out from a specific trading range. When the price is oscillating within a certain range and then a breakout occurs, the Two Bollinger Bands strategy can generally be used to avoid false breakouts.
Below is an example of a breakout scenario using Two Bollinger Bands on the EURGBP chart. As you can see, the price has been oscillating within a range until it ultimately breaks out of this range. The price then reaches the buy zone with strong momentum.
To confirm the breakout, traders can look for an increase in the distance between the Bollinger Bands. Another confirmation is that a bullish candlestick closes above the upper Bollinger Band.
To exit the trade, traders can wait for a decrease in momentum or use other methods such as a trailing stop-loss. As long as the price remains in the buy zone, the trade can be kept open.
Trend Method
With the Two Bollinger Bands strategy, a trader can identify the prevailing trend in the market. When the price exits either side of the Bollinger Bands, it presents an opportunity to enter a buy (or sell) position. Traders can remain in the trade as long as the price continues to move in the desired trend.
The key is to track the price movement after it exits the bands; if it crosses the 20-day moving average and maintains its position above it, traders can continue to ride the trend. It is advisable to set stop-loss orders at important support and resistance levels to manage risk effectively while staying with the ongoing trend.
Bollinger Band Width Reduction Strategy
The Bollinger Band Width Reduction strategy helps analyze market volatility. This indicator works based on price fluctuations; when the Bollinger Bands expand, it indicates high volatility, and conversely, when the bands contract, it signifies a reduction in volatility, reflecting a calmer market state.
Traders often view the contraction of Bollinger Bands as a signal for a potential sudden price movement following a period of lower volatility. In other words, when these bands enter a narrower range, it may indicate preparation for a price surge or direction change. This strategy aids in identifying optimal entry or exit points for trades, especially when the market is gearing up for a significant change.
Unfortunately, the Bollinger Band Width indicator does not provide us with entry and exit levels, so we need to use other technical methods to identify entry and exit points.
Bollinger Band Reversal Strategy
As volatility increases in price, we observe a rise in the Bollinger Band Width indicator. This can be clearly seen in the USDJPY chart. When the currency pair reaches its lowest point, volatility increases, causing the Bollinger Band Width indicator to peak.
At this point, a trade can be initiated, as it is expected that volatility will decrease again afterward. However, as mentioned earlier, the Bollinger Band Width indicator does not provide us with specific entry and exit levels, so it is necessary to use other technical tools for this purpose.
What is the best Bollinger Bands strategy?
According to the author of the article, the second trading strategy is a better option for Bollinger Bands because volatility and volume are mutually connected. Therefore, their significance to each other is essential, which in turn generates reliable signals for trading. When the price moves significantly beyond one of the bands in the direction of high volatility and trading volume, we are likely to witness a large price movement in the future.
Additionally, the clear rules for entering and exiting trades make the execution of this type of Bollinger Bands strategy straightforward.
The Bollinger Bands strategy is also compatible with candlestick patterns. However, it is less likely to capture a large price movement.
Thus, to mitigate the risk of counter-trend movements, it is suggested to close half of the position when a simple moving average breakout occurs. Some traders prefer this type of trade setting, which has been proven effective, but the trader must be aware that these setups require more than just a counter-trend strategy and need more precise control in the realm of risk management.
Limitations of Bollinger Bands
The Bollinger Bands indicator is not an independent trading system. These bands are merely an indicator that provides traders with information about price volatility. John Bollinger suggests using Bollinger Bands alongside two or three uncorrelated indicators (meaning their calculations are not the same as those of the Bollinger Bands) to receive clearer signals. He believes that it is very important to use indicators based on different types of data. Some of his favorite technical indicators include the Relative Strength Index (RSI), Moving Average Convergence Divergence (MACD), and On-Balance Volume (OBV).
Since Bollinger Bands use a simple moving average, they give equal weight to both old and new data. Additionally, applying a 20-day moving average and 2 standard deviations may not be beneficial in every situation. Traders should adjust the indicator to their trading strategy while being aware of the assumptions underlying this indicator.
Conclusion
Bollinger Bands are a volatility-based indicator consisting of an upper and a lower band, which react to price fluctuations and a 20-period simple moving average. The calculation involves a 20-period simple moving average and a standard deviation, typically set at 2.
Key signals from the Bollinger Bands indicator include:
- Contraction of the bands: Indicates a potential future breakout and increased volatility.
- Price touching the lower band: A classic buy signal; however, if the price drops below it, a downtrend with high volatility may continue.
- Price touching the upper band: A classic sell signal; if the price rises above it, the upward trend may persist.
- Breakout of the moving average: A valid signal indicating the direction of the breakout.
Two of the best trading strategies for Bollinger Bands are:
1. Combining MQL5 Bollinger Band price signals with candlestick patterns.
2. Breakouts of the Bollinger Bands confirmed by volume indicators.
The preferred trading setup focuses on MQL5 Bollinger Band price breakouts confirmed by volume, as it provides clear rules, easy execution, and reliable signals that lead to larger, longer-lasting price trends.
