Bollinger bands can be utilized in many ways. They can forecast upcoming volatility in the market, identify overbought and oversold levels or be used to locate support and resistance levels.
Bollinger bands essentials
- Bollinger bands are a type of technical indicator.
- They consist of a moving average in the middle and trading bands on the sides.
- When the price is flat, the trading bands move close to the moving average.
- Conversely, volatility makes trading bands expand in opposite directions.
- Bollinger bands are used to predict upcoming market volatility, determine where support and resistance levels are and identify overbought and oversold levels.
How do trading bands move?
The elements that form Bollinger bands (a moving average and its two trading bands) all move simultaneously, and their movement is tied to the asset’s price. The moving average follows the price movement with some delay, but the trading bands behave a bit differently.
When the price makes a significant move, the trading bands move in opposite directions, away from the moving average. The bigger the price move is, the wider the trading bands’ expansion, forming a broad channel between them.
The movement of the trading bands works differently when the market is not experiencing much volatility. In this case, the trading bands move close to each other, aligning in parallel with the moving average. The flatter the price action is, the tighter the channel which is formed by the trading bands.
Using Bollinger bands
There are several ways in which Bollinger bands can be used. Primary among these are forecasting volatility, determining where support and resistance are located, or identifying overbought and oversold levels.
Volatility
One of the prime and most popular use cases of Bollinger bands is to forecast big upcoming price movements; in other words, to predict volatility. When the price is flattening and the trading bands are tightening, there is usually a price move incoming. As the channel formed by the trading bands tightens, the chance that a price movement will occur becomes more imminent.
Utilizing this indicator is therefore very useful when trying to catch a perfect trade entry (or exit) just before the price bursts (or plummets). When Bollinger bands are applied to wider time frames, the trading bands tightening could potentially forecast a substantial price change.
However, the tightening of the trading bands only implies that a price move is coming, but it doesn’t predict where the price might move to. Therefore, Bollinger bands should not be used as a standalone indicator, even if some consider them the best indicator for predicting market volatility.
Support and resistance
When using Bollinger Bands to determine where support and resistance lie, it is best to concentrate on the moving average which runs in the middle. As the majority of price movement happens between the trading bands, the moving average acts as local support or resistance. If the price is above the moving average, it acts as support and if the price is below the moving average, it acts as resistance.
Overbought and oversold levels
Price movement mostly happens inside the trading bands. Every significant price breakout outside the trading bands expands them radically. If candles start opening outside the trading bands, this is a potential sign that the price has entered overbought or oversold levels and it might correct soon. However, traders must acknowledge that, in a strong bull or bear trend, extreme indicator conditions can last for some time before returning to normal.
Bollinger bands are a versatile indicator and can be used in various ways. Their most unique, often-used feature helps predict upcoming market volatility. Regardless of their standalone prowess, it is best to combine Bollinger bands with complementary technical indicators and tools.