Bollinger Bands - Timing Trades with Volatility

What are Bollinger Bands

Bollinger Bands is a volatility-based technical indicator developed by John Bollinger in the 1980s. It draws three lines (bands) on the price chart, showing at a glance whether the current price is relatively high or low, and what state market volatility is in.

What makes Bollinger Bands unique is that the band width automatically adjusts based on market volatility. When volatility increases, the bands widen; when volatility decreases, the bands narrow. This is a key characteristic that distinguishes it from many other indicators that use fixed ranges.

When John Bollinger created this indicator, he presented over 20 rules for its use. The most important one is this:

Bollinger Bands provide a definition of relative high and low prices. At the upper band, price is relatively high; at the lower band, price is relatively low.

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Structure of Bollinger Bands: 3 Lines

Bollinger Bands consist of three lines.

Middle Band

This is the 20-day simple moving average (SMA). It serves as the baseline for the bands, representing the medium-term average price.

Middle Band = 20-day SMA

As discussed in Moving Averages, the 20-day moving average represents approximately four weeks of average price and serves as a reference line for medium-term trend direction.

Upper Band

The middle band plus two standard deviations.

Upper Band = 20-day SMA + (2 x 20-day Standard Deviation)

Lower Band

The middle band minus two standard deviations.

Lower Band = 20-day SMA - (2 x 20-day Standard Deviation)

What Standard Deviation Means

Standard Deviation (SD) is a statistical measure of how spread out data is from the mean. A large standard deviation means price fluctuations are large; a small one means prices are clustered near the average.

Assuming a normal distribution, approximately 95% of data falls within two standard deviations of the mean. Applied to Bollinger Bands, this means approximately 95% of price action occurs between the upper and lower bands. Of course, financial market price distributions aren't perfectly normal, so this percentage is an approximate reference.

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What Band Width Tells You

One of the most important pieces of information from Bollinger Bands is the width of the bands themselves.

When Bands are Wide (High Volatility)

A wide distance between the upper and lower bands means recent price volatility is high. There has been or currently is significant price movement.

• Bands widen after sharp rallies or declines.
• When bands begin to narrow after widening, it signals volatility is decreasing.

When Bands are Narrow (Low Volatility)

When the upper and lower bands are close together, it means recent price movement has been minimal. This typically indicates a quiet market, likely in a consolidation phase.

• Narrowing bands can signal energy is being accumulated.
• Large price movements tend to follow periods of narrow bands.

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The Squeeze

The most famous and powerful pattern in Bollinger Bands is the squeeze.

A squeeze occurs when the band width becomes extremely narrow. This indicates market volatility has become very low, suggesting a large price move is likely imminent.

Volatility cycles between expansion and contraction. When volatility becomes extremely low (squeeze), it tends to expand significantly afterward.

How to Use the Squeeze

1. Check if band width has narrowed to its minimum level in the past 6 months.
2. In a squeeze state, direction is hard to predict, so wait for a breakout direction.
3. If price breaks above the upper band, a significant upward move is likely; if it breaks below the lower band, a significant downward move is likely.
4. Volume accompanying the breakout increases signal reliability.

The squeeze doesn't tell you "which direction price will move," but it's highly useful because it warns "a big move is coming soon." Direction can be confirmed with MACD or moving average alignment.

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Band Walk

Band walk refers to price moving tightly along the upper or lower band, as if "walking" along it.

Upper Band Walk

In a strong uptrend, price moves along the upper band. Candles open and close above the upper band or consistently touch it.

Lower Band Walk

In a strong downtrend, price moves along the lower band. Candles open and close below the lower band or consistently touch it.

The Key Lesson of Band Walk

Band walk is directly related to the most common mistake beginners make.

Don't sell just because price touches the upper band. Don't buy just because price touches the lower band.

In strong trends, price continues moving in the same direction even after touching the band edge. Simply using upper band touches as sell signals and lower band touches as buy signals leads to counter-trend trading and potentially significant losses.

To check if a band walk is in progress, reference the ADX. If ADX is above 25, confirming a strong trend, avoid reversal trades at band edges.

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Bollinger Bands Trading Strategies

Strategy 1: Band Bounce in Ranging Markets

Capitalizes on price oscillating between bands in trendless consolidation phases.

1. Confirm a ranging market with ADX below 20.
2. Buy when price touches the lower band; sell when it touches the upper band.
3. Set the middle band (20 SMA) as your target.
4. Stop loss if price breaks outside the band.

Strategy 2: Breakout After Squeeze

Capitalizes on volatility expansion following contraction.

1. Detect an extremely narrow squeeze state.
2. Buy if price breaks above the upper band; sell if it breaks below the lower band.
3. Confirm volume increases after the breakout.
4. Use the middle band (20 SMA) as a stop loss reference.

Strategy 3: Band Walk Trend Following

Follows strong trends along the bands.

1. When price begins walking along the upper band, maintain long positions.
2. Consider exiting when price falls below the middle band.
3. Conversely, maintain short positions during lower band walks.

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Combining with RSI

Using Bollinger Bands with RSI can increase signal reliability.

Strong Buy Signal

• Price touches the lower Bollinger Band.
• Simultaneously, RSI is in the oversold zone below 30.
• Both indicators pointing to oversold increases bounce probability.

Strong Sell Signal

• Price touches the upper Bollinger Band.
• Simultaneously, RSI is in the overbought zone above 70.
• Both indicators pointing to overbought increases correction probability.

However, this combination should not be applied during band walks. In strong trends, price can remain at the upper band while RSI stays overbought for extended periods.

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Common Mistakes and Cautions

Mistake 1: Treating Band Touches as Automatic Reversals

As explained in band walk, price touching the band doesn't mean it will necessarily reverse. Check trend strength first.

Mistake 2: Interpreting Candles Outside Bands as Anomalies

Price moving outside the bands is not abnormal. It happens naturally in strong trends. Outside-band candles simply indicate "price is at an extreme position relative to current volatility."

Mistake 3: Relying Only on Default Settings

The (20, 2) settings aren't optimal for all situations. In highly volatile markets like cryptocurrencies, consider slightly increasing the period (e.g., 21-25) or raising the standard deviation multiplier to 2.5.

Mistake 4: Using Bollinger Bands Alone

John Bollinger himself recommends using Bollinger Bands with other indicators. The bands provide information about volatility and relative price levels, but confirmation of trend direction and momentum should come from indicators like MACD, RSI, and Stochastic.

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Key Takeaways

1. Bollinger Bands automatically adjust to volatility, defining relative high/low prices.
2. A squeeze (narrowing bands) is an early warning of significant price movement.
3. Avoid counter-trend trades at band edges during band walks.
4. Band bounce strategy works in ranging markets; band walk following works in trending markets.
5. Use in combination with RSI, MACD, and other indicators for best results.

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Next article: ATR - Reading Volatility in Numbers