Bollinger Bands ® are among the most reliable and potent trading indicators traders can choose from. They can be used to read the trend strength, to time entries during range markets and to find potential market tops. The indicator is also not a lagging indicator because it always adjusts to price action in real time and uses volatility to adjust to the current environment.
In this article, we show you how to use Bollinger Bands ® to improve your chart reading skills and how to identify high probability trade entries.
Bollinger Bands ® explained 101
As the name implies, Bollinger Bands ® are price channels (bands) that are plotted above and below price.
The outer Bollinger Bands ® are based on price volatility, which means that they expand when the price fluctuates and trends strongly, and the Bands contract during sideways consolidations and low momentum trends.
By default, the Bollinger Bands ® are set to 2.0 Standard deviations which means that, from a statistical perspective, 95% of all the price action happens in between the channels. A move close to the, or outside of the outer Bollinger Bands ® shows a significant price move – more on that later.
The center of the Bollinger Bands ® is the 20-period moving average and the perfect addition to the volatility based outer bands.
Trend-trading with the Bollinger Bands ®
Bollinger Bands ® do not lag (as much) because they always change automatically with the price.
We can use the Bollinger Bands ® to analyze the strength of trends and get a lot of important information this way. There are just a few things you need to pay attention to when it comes to using Bollinger Bands ® to analyze trend strength:
- During strong trends, price stays close to the outer band
- If price pulls away from the outer band as the trend continues, it shows fading momentum
- Repeated pushes into the outer bands that don’t actually reach the band show a lack of power
Chart analysis with Bollinger Bands ®
The screenshot below shows how much information a trader can pull from using Bollinger Bands ® alone. Let me walk you through the points 1 to 5:
1) Price is in a strong downtrend and price stays close to the outer bands all the time. This is a very bearish signal.
2) Price fails to reach the outer band and then shots up very strongly. Suddenly failing to reach the bands can signal fading momentum.
3) 3 swing highs with lower highs: the first swing high reached the outer band whereas the following two failed. A bearish signal.
4) A strong downtrend where price stayed close to the outer band. It tried to pull away, but bears were always in control.
5) Price consolidates sideways, not reaching the outer band anymore and the rejection-pinbar ended the downtrend.
As you can see, the Bollinger Bands ® alone can provide a lot of information about trend strength and the balance between bulls and bears.
Finding tops and bottoms with Bollinger Bands ®
We highly recommend combining the Bollinger Bands ® with the RSI indicator – it’s the perfect match. There are two types of tops that you need to know about:
2) During a consolidation, price spikes into the outer Bands which get rejected immediately
The screenshot below shows both scenarios. The first is the top after a divergence. You can see how the trend became weaker and then eventually failed to reach the outer Band before reversing. I marked the second spike with an arrow which was a trend continuation signal as price failed to break higher during the downtrend. The strong spike that was followed by a fast rejection showed that bulls lacked power.
You can see that the Bollinger Bands ® are a multi-faceted trading indicator that can provide you with lots information about the trend, buy/seller balances and about potential trend shifts. Together with the moving average and the RSI, Bollinger Bands ® make for a great foundation for a trading strategy.
See the Bollinger Bands ® in action