Bollinger Bands Explained
Bollinger Bands are a popular technical indicator which use standard deviation to establish where a band of likely support and resistance levels might be found. This is a specific utilisation of a broader concept known as a volatility channel.
A volatility channel plots lines above and below a central measure of price. These lines, also known as envelopes or bands, widen or contract according to how volatile or non-volatile a market is. Bollinger Bands measure market volatility and provide lots of useful information, including:
Trend continuation or reversal
Periods of market consolidation
Periods of upcoming large volatility breakouts
Possible market tops or bottoms and potential price targets
Bollinger Bands consist of three lines, the middle of which is a Simple Moving Average (SMA) with the default value of 20. The upper and lower band are found two standard deviations either side of the SMA.
How do Bollinger Bands Work?
The most basic interpretation of Bollinger Bands is that the channels represent a measure of 'highness' and 'lowness'. Let's sum up three key points about Bollinger bands:
The upper band shows a level that is statistically high or expensive
The lower band shows a level that is statistically low or cheap
The Bollinger Band width correlates to the volatility of the market
- In a more volatile market, Bollinger Bands widen
- In a less volatile market, the bands narrow
The Bollinger Bands contain a default setting in Forex trading as (20,2) - where 20 is the value for the SMA and 2 refers to the number of standard deviations the upper and lower band are either side of the SMA.
When using trading bands, it is the price action as it nears the edges of the band that should be of particular interest to us. For a technical analyst, trading near the outer bands provides an element of confidence that there is resistance (at upper boundary) or support (at bottom boundary), however, this alone does not provide accurate buy or sell signals. All that it determines is whether the prices are high or low, on a relative basis.
Bollinger Bands can be applied to virtually any market or security. For beginners, the default Bollinger Band settings are a good starting point.
As you lengthen the number of periods of the bands, you need to increase the number of standard deviations used. At 50 periods, two and a half standard deviations are a good selection, whilst at 10 periods, one and a half perform the job quite well.
The Bollinger Bands Formula
The default Bollinger Bands® formula consists of:
An N-period moving average (MA)
An upper band at K times and an N-period standard deviation above the moving average (MA + Kσ)
A lower band at K times and an N-period standard deviation below the moving average (MA − Kσ)
Double Bollinger Band Strategy
Now we understand this technical indicator better, it is time to look at our first Bollinger Bands strategy.
The Double Bollinger Band Strategy is a Forex trading strategy popularised by Kathy Lien, a well-known Forex analyst and trader, who wrote in her book 'The Little Book of Currency Trading' that this was her favourite trading method.
The Double Bollinger Band Strategy is simple to learn and can be used for any actively traded asset on big liquid markets, such as Forex, stocks and commodities. As the name suggest, it requires adding two sets of Bollinger Bands to a single price chart.
Double Bollinger Bands Settings
This is how you apply the Double Bollinger Bands settings in MetaTrader 4:
Click the ‘Insert’ menu at the top of the screen, select ‘Indicators’, ‘Trend’ and then ‘Bollinger Bands’
Set the ‘Period’ as 20 and ‘Deviations’ as 2, leave ‘Shift’ as the default 0
Insert a second set Bollinger Bands with a different colour
For the second indicator, set the ‘Period’ as 20 and ‘Deviations’ as 1, leave ‘Shift’ as the default 0 again
In the chart above, the Bollinger Bands in blue have settings of (20,2) and its outer bands are marked A1 and A2. The red Bollinger Bands have settings of (20,1) and its outer bands are marked as B1 and B2. Their shared SMA is labelled X.
The Double Bollinger Band Strategy contains three distinct trading zones:
The Buy Zone is between lines A1 and B1
The Neutral Zone is between lines B1 and B2
The Sell Zone is between lines B2 and A2
The DBB Buy Zone
When the price is within the buy zone, it tells us that the uptrend is strong, and that there is a higher chance that the price will continue upward.
As long as the price candles continue to close in the buy zone, the odds favour maintaining current long positions or even opening new ones.
The DBB Sell Zone
When the price is in the sell zone, a downtrend will probably continue. That tells us that as long as the candles close in the lowest zone, a trader should maintain current short positions or open new ones.
The DBB Neutral Zone
When the price gets within the area defined by B1 and B2, the neutral zone, there is no strong trend, and the price is likely to fluctuate within a trading range because momentum is no longer strong enough for traders to continue the trend. The 20-day simple moving average (X) that serves as the baseline for both Bollinger Bands is in the centre of the zone.
According to the rules, whichever zone the price is in will signal whether you should be trading in the direction of the trend, long or short.
Basically, if the price is in the buy zone, you go long, if it's in the sell zone, you go short. If the price is in the two middle quarters (the neutral zone), you should restrain from trading if you are a pure trend trader, or trade shorter-term trends within the prevailing trading range. Usually, with the Double Bollinger Bands Strategy, traders trade higher time frames such as H4 or daily.
Our indicators page offers a free Double Bollinger Band strategy indicator and monitor.