How Do Bollinger Bands Work? 4 Useful Insights from the Indicator


Today we are going to discuss how do Bollinger Bands work. The indicator in question is probably familiar to anyone who has done a little technical analysis. The indicator developed years ago by John Bollinger is one of the most frequently used indicators.

Key Takeaways🔑

Bollinger Bands is a widely-used technical analysis tool for identifying price trends, volatility, and momentum.
Using Bollinger Bands can help you identify potential breakouts, reversals, and support and resistance levels in the market.
Combining Bollinger Bands with other technical indicators, like RSI, can improve the accuracy of your trading signals.
Bollinger Bands can also be used to manage risk by setting stop-loss orders or trailing stops.

How Bollinger Bands indicator is constructed?

Bollinger Bands is an indicator that sets the range of asset price movement. It is built on the basis of three moving averages one in the middle and two others located the same distance from the first one. Range width is calculated by the mathematical formula of standard deviation.

Bollinger Bands
Bollinger Bands

Its coefficient may be set in the indicator settings. The higher the coefficient the wider the range and the more infrequently the chart reaches borders.

The higher the coefficient the wider the range
The higher the coefficient the wider the range

Period is a number of candlesticks used in the calculation of indicator parameters. Increasing period smooth the corridor but does not guarantee an increase in indicator performance accuracy.

Increasing period smooth the corridor
Increasing period smooth the corridor

How do Bollinger Bands work?

When the price approaches or touches one of the lines, the probability of its movement shifts to the opposite direction.

How do Bollinger Bands work?
Price behaviour on the corridors barrier

The breakdown of one of the lines signals probable trend movement towards the breakdown. This type of behaviour can be used in a Bollinger Band breakout strategy.

Trend movement
Trend movement

The higher the volatility on the market the higher the corridor.

Volatility affects corridors range
Volatility affects corridors range

Long term location of the indicator is in a narrow range. Usually preceding upheaval in the market.

It's good to use additional tools with Bollinger Bands
It’s good to use additional tools with Bollinger Bands

How to use Bollinger Bands

With the principles of the Bollinger Bands indicator mentioned earlier, it is quite easy to imagine what specific signals it can generate for trading. Here we could distinguish 2 basic types of signals:
Bounces from the upper and lower bands. Seeing that the price respects these lines you can sell on the upper and buy on the lower band.

Breakouts from the upper and lower bounds. If the market dynamically crosses the upper band upwards it may be a buy signal. Conversely, if the price dynamically breaks through the lower band it may be used as a sell signal.

Additionally, it is worth observing the width of the band in order to know what is the current situation on a given asset. If the band is wide, we are usually dealing with a strong trend and high volatility. At such moments it is worth using additional tools to join the trend. If the band is narrow, it is usually due to a consolidation of the market. In such a scenario I personally prefer to wait for a directional breakout and only then look for a signal to enter a position.

The Bollinger Bands indicator is best used in combination with other indicators. By the time a strong trend takes place. This indicator alone becomes ineffective.

We highly encourage you to read our guides on how to trade using Bolliger Bands and pin bars and how to combine Bollinger Bands with RSI oscillator to know more about how do Bollinger Bands work.

4 Useful Insights from the Indicator

Bollinger Bands are one of the most popular technical analysis indicators used by traders worldwide. They were created by John Bollinger in the 1980s and are widely used to identify potential price trends, volatility, and momentum. In this article, we will dive into the details of how Bollinger Bands work and provide you with four useful insights to help you become a better trader.

Insight #1: Understanding the Basics of Bollinger Bands

Bollinger Bands consist of three lines, which are plotted using a moving average and two standard deviations. The middle line is the simple moving average, while the upper and lower bands represent the standard deviations. The distance between the upper and lower bands will change according to the level of volatility in the market. When the market is highly volatile, the distance between the bands will increase, indicating a potential price movement.

Traders use Bollinger Bands to identify the support and resistance levels. When the price moves towards the upper band, it indicates a potentially overbought market, while a move towards the lower band indicates an oversold market. However, it’s important to note that Bollinger Bands are not always accurate and should be used in combination with other technical indicators.

Insight #2: Identifying Breakouts and Reversals

Bollinger Bands can also be used to identify potential breakouts and reversals in the market. When the price moves beyond the upper or lower band, it’s considered a breakout. A breakout indicates that the price has broken through a significant level of support or resistance, which could lead to a significant price movement in that direction.

On the other hand, a reversal occurs when the price moves from an overbought or oversold condition and moves back towards the moving average. This could indicate that the current trend is losing momentum, and a reversal may be imminent.

Insight #3: Combining Bollinger Bands with Other Indicators

Bollinger Bands work best when used in combination with other technical indicators. One popular indicator to combine with Bollinger Bands is the Relative Strength Index (RSI). The RSI measures the strength of a security’s price action and is often used to identify overbought and oversold conditions.

When the RSI is overbought and the price is at the upper band, it could indicate a potential reversal. Conversely, when the RSI is oversold, and the price is at the lower band, it could indicate a potential reversal to the upside.

Insight #4: Using Bollinger Bands to Manage Risk

Bollinger Bands can also be used to manage risk when trading. Traders can use the bands to set stop-loss orders or trailing stops. When the price moves outside the upper or lower bands, it could indicate that the trend is reversing, and traders may want to exit their position. By setting a stop-loss order just outside the bands, traders can limit their potential losses and protect their capital.

Additionally, traders can use Bollinger Bands to set profit targets. When the price reaches the upper band, it could indicate that the trend is becoming overextended, and traders may want to take profits. By setting a profit target just below the upper band, traders can lock in their profits and exit the trade.

Pros and Cons of Bollinger Bands📊

Pros😃:

  • Helps to identify potential price trends and market volatility.
  • Easy to interpret and implement in trading strategies.
  • Can be combined with other technical indicators for improved accuracy.
  • Useful for risk management through setting stop-loss orders or trailing stops.

Cons😔:

  • Not always accurate in predicting market movements.
  • May generate false signals during periods of low volatility or sideways trends.
  • Requires additional indicators for optimal performance.
  • Not a standalone trading system; should be used as part of a comprehensive strategy.


Trading Strategy Description
Bollinger Bands Bounce Buy when the price touches the lower band and sell when the price touches the upper band, assuming the price will bounce back within the range.
Bollinger Bands Breakout Buy when the price breaks above the upper band and sell when the price breaks below the lower band, anticipating a trend in the breakout direction.
Bollinger Bands with RSI Use the Relative Strength Index (RSI) in conjunction with Bollinger Bands to confirm overbought and oversold conditions for potential reversals.
Bollinger Bands Squeeze Monitor narrow bands for potential breakouts following periods of low volatility and market consolidation.

Conclusion

In conclusion, Bollinger Bands are a versatile technical analysis tool that can be used to identify potential price trends, volatility, and momentum. Traders can use Bollinger Bands to identify breakouts and reversals, manage risk, and set profit targets. However, as with any technical indicator, Bollinger Bands are not always accurate and should be used in combination with other technical indicators.

We wish you successful trading on the IQ Option platform.


Short Q&A on Bollinger Bands📝

  • Q: What is the primary purpose of Bollinger Bands?
    A: Bollinger Bands are primarily used to identify potential price trends, volatility, and momentum in the market.
  • Q: How are Bollinger Bands constructed?
    A: Bollinger Bands consist of three lines – a simple moving average (middle line), and two standard deviations (upper and lower bands).
  • Q: How can Bollinger Bands help identify breakouts and reversals?
    A: When the price moves beyond the upper or lower band, it’s considered a breakout, while a reversal occurs when the price moves back towards the moving average from an overbought or oversold condition.
  • Q: Should Bollinger Bands be used alone or in combination with other indicators?
    A: Bollinger Bands are most effective when used in combination with other technical indicators, such as the Relative Strength Index (RSI), to improve the accuracy of trading signals.
  • Q: How can Bollinger Bands be used for risk management?
    A: Bollinger Bands can help manage risk by setting stop-loss orders or trailing stops based on the distance between the bands and the current price.

GENERAL RISK WARNING

The financial products offered by the company carry a high level of risk and can result in the loss of all your funds. You should never invest money that you cannot afford to lose.
Kindly note that this article does not provide any investment advice. The information presented regarding past events or potential future developments is solely an opinion and cannot be guaranteed as factual, including the provided examples. We caution readers accordingly.

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Bart Bregman

Author / IQ Option expert: "My name is Bart Bregman, I have 9 years of full-time professional trading experience. I've been trading with IQ Option for more than 7 years, mainly on the shorter time frames doing technical analyses, and have many experience with Binary Options, CFDs, Options, and Crypto trading. There is no such thing as a bad trade! As a digital nomad trader, I'm mostly traveling all over the world. Follow my journey on Instagram at https://www.instagram.com/bart_bregman/. "

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