Bollinger Bands for Beginners

You’ve probably seen those bands on a price chart and wondered what they mean or how they can help you in trading.

But don’t worry, Bollinger Bands are simpler than they appear. Once you understand the basics, you’ll see how they can, together with other indicators, help you make better trading decisions.

In this article, we’ll learn what they are and how to interpret them on a chart. By the end, you’ll be ready to incorporate Bollinger Bands into your analysis and make more informed trading decisions.

What are Bollinger Bands?

Bollinger Bands are a type of technical analysis tool developed by John Bollinger in the 1980s. They consist of three lines: a middle band (usually a simple moving average), an upper band, and a lower band. These bands are plotted two standard deviations away from the middle band.

In this context, a standard deviation is a measure of how spread out the prices are from the average price over a specific period. It helps to understand how much the price typically varies. Here’s a simple way to think about it:

• If prices are close to the average: The standard deviation is small, meaning the price doesn’t vary much.
• If prices are spread out: The standard deviation is large, meaning the price varies a lot.

How Standard Deviation Works in Bollinger Bands:

• Middle Band (Simple Moving Average, SMA): Calculate the average price over a specific period, typically 20 days / weeks / months or whatever period you’re using.
• Calculate Standard Deviation:
  • Look at how much each price in the period deviates from the average price.
  • Average these deviations to understand the typical price variation.
• Upper Band: Add two standard deviations to the middle band.
• Lower Band: Subtract two standard deviations from the middle band.

By using standard deviation, Bollinger Bands adjust to market conditions, expanding during volatile periods and contracting during stable periods. This helps traders identify whether prices are relatively high or low compared to the recent past.

Components of Bollinger Bands

1. Middle Band (Simple Moving Average, SMA): Typically, a 20-period SMA is used.
2. Upper Band: This is the middle band plus two standard deviations.
3. Lower Band: This is the middle band minus two standard deviations.

This means:

• When prices are more volatile (more spread out), the bands widen.
• When prices are less volatile (closer together), the bands narrow.

How to Interpret Bollinger Bands

John Bollinger, the creator of Bollinger Bands, explains it best:

Bollinger Bands answer a question: Are prices high or low on a relative basis? By definition price is high at the upper band and price is low at the lower band. That bit of information is incredibly valuable. It is even more powerful if combined with other tools such as other indicators for confirmation.

Simplified Explanation:

• Relative Price Levels: Bollinger Bands help you see if prices are relatively high or low. If the price is near the upper band, it’s high compared to recent prices. If it’s near the lower band, it’s low.
• Trading Value: Knowing if a price is high or low can help you make better trading decisions.
• Enhanced Analysis: Bollinger Bands are even more useful when used with other indicators, giving you a clearer picture of market conditions.

Key Insights

Bollinger Bands are a versatile tool that can provide insights into support and resistance, and trend direction across different timeframes, such as daily, weekly, and monthly charts. Here’s how you can use them effectively in your trading:

• Support and Resistance with 20 MA:
  • The middle band of Bollinger Bands, typically a 20-period moving average (MA), acts as a dynamic support and resistance level. Prices often bounce off this MA during trends.
• Trend Determination:
  • Use Bollinger Bands on a monthly chart to identify long-term trends.
  • When the lower band expands downward, it indicates the security is rising higher, suggesting you ride the trend.
  • If the lower band starts to curl up, it could signal a potential trend change or slowdown.
• Volatility and Breakouts:
  • Tight Bollinger Bands suggest low volatility and often precede a breakout. Expect a significant move to the upside or downside when the bands are very tight.
• Confluence With Other Indicators:
  • Combining Bollinger Bands with other technical indicators can add more confluences to your analysis, enhancing your trading decisions.
• Entry and Exit Points:
  • On a monthly chart, hitting or breaking through the lower Bollinger Band can signal a good entry point, especially when combined with other indicators. Price tends not to stay outside the bands on a monthly chart for long.
  • If the price is way above the upper Bollinger Band, consider taking profits as the price may move back down.

By using Bollinger Bands alongside other technical analysis tools, you can gain a comprehensive understanding of market conditions and make more informed trading decisions.