What is a Bollinger Band

The Bollinger Bands is a technical analysis tool created by John Bollinger in the 80s. Because of it's simplicity, the Bollinger Bands is popular trading tools used by stocks, derivatives, currencies and even bond traders from around the world. In the next few minutes, let me share with you the functions of Bollinger Bands and how you can use it to compliment your existing strategies.

The Bollinger Bands consists of 3 things:

1. A Middle band, which is a moving average
2. An Upper Band (at K multiples an N-period standard deviation above the moving average (MA + Kσ) )
3. A Lower Band (at K multiples an N-period standard deviation below the moving average (MA + Kσ) )

The most commonly used parameters are (20, 2) while there are traders, who prefer to have more sensitive price actions, adjusted the standard deviation to 2.5% to become (20, 2.5). The (14, 4) is also a popular combination. Besides that, traders can also choose to use either simple or exponential moving average and adjust its moving average period according to their trading styles.

Regardless what settings were used, no combination is 100% accurate. What matters is how it may be useful in your trading decision. Let us explore how Bollinger Bands may work for us.

How and when to use this strategy

The main function of the Bollinger Bands is to inform traders of potential market highs and lows. Prices that is trading in the upper bands means prices are high and vice versa. The use of Bollinger Bands varies widely among traders. Let us explore a few of the popular options.

# 1: Contrarian method & its Pros & Cons

For traders who want to trade against the trends, although it is not profitable most of the time, Bollinger Bands can be used to identify overbought and oversold levels. These contrarian traders tend to buy when prices hit the lower band and sell when prices hit the upper band. They hoped that Bollinger Bands reduce their fear of buying at high price or selling at low prices. I will use a FCPO market to illustrate this.

As you can see, FCPO is in an uptrend and traders who want to trade against this uptrend can use the upper band as signals to place their shorts. However, as you can see again, not all trades are successful. Some managed to drop significantly to give a big enough profits while some only manage to drop further a little.

# 2: Sideways market & its Pros & Cons. 

Since Bollinger Bands sometimes able to help trader identify overbought and oversold levels, there are traders that use this indicator to make trading decisions during a range bound markets. These traders buy when prices hit the lower band and sell when prices hit the upper band. Keep in mind, this technique works if the market is in a sideways trend. This method is dangerous to your account if prices are in a strong uptrend or downtrend.

John Bollinger also said: "tags of the bands are just that – tags, not signals. A tag of the upper Bollinger Band is not in and of itself a sell signal. A tag of the lower Bollinger Band is not in and of itself a buy signal." What he means that prices sometimes "walk along the band" and trades who continuously try to sell the top or buy the bottom may face serious losses.

# 3: Basic trend identification & its Pros & Cons

Bollinger Bands also can be used to identify market trends. If prices "walk along the lower band", it means prices are in a strong downtrend. The downtrend turns weak if prices start moving towards the middle band.

On the other hand, if prices "walk along the upper band", it shows the market is in a strong uptrend. The trend is turning weak if prices moving towards the middle band. Check out the chart below:

When prices "walks along" the lower band it means prices has a high chance of continuing a downtrend, as shown in point 1 and 2. When prices are in the upper band, it show market has the tendency of going upwards.

Risk management with this strategy 

The Bollinger Band is not a perfect indicator and it has its drawbacks too as discussed above. Therefore traders must put stop losses, regardless whether you are a contrarian, trading in the sideways market or a trend follower.

#1 for contrarian / sideways market trader

Traders who are contrarian or trading the sideways market can put a stop loss order below the lower band if long the market. On the other hand, a stop loss can be placed just above the upper band for those who short the market. Keep in mind, make sure these lower/upper bands cut loss orders do not go against your risk to reward ratio.

#2 for those who trade the trends

Traders can use the middle band as a risk management tool. For traders who want to follow the current uptrend, a stop loss can be placed just below the middle band. For traders that short the market can place a stop loss just above the middle band. Friendly reminder, make sure the middle band do not cause you more losses than you are comfortable with.

Conclusion

Bollinger Bands are popular to the majority of traders out there because it caters to the contrarians, sideways traders and even some trend followers. However, like any indicator or naked price action strategy, Bollinger Band is not 100% accurate. Therefore it is important for traders to put stop losses. And you can use Bollinger Band to improve your current trading strategy.

Besides that, traders can also use a variety of methods to filter out the low quality trades. In our TFM community, you will learn how we hunt for the high quality trades with a few practical price action analysis and indicators. You will learn our exact trading method step by step so you can enjoy the juiciest trends. Feel free to ask if you have any questions. Good luck in your trading!