Bollinger Bands are a technical analysis indicator, that was first introduced in the 1980`s by long-time technician John Bollinger. Indicator’s main purpose is to predict the future behavior of the price chart.
Bollinger Bands consist of a moving average and two trading bands. The latter are the result of adding (subtracting) a standard deviation to (from) a normal moving average. In statistics, the standard deviation is a measure that is used to qualify the amount of variation. In technical analysis, the standard deviation (SD) is used to estimate price volatility of an asset.
In other words, the higher the standard deviation the wider the price range of an underlying asset for the given period of time. Measuring how far the price can deviate from its average value is helpful when one wants to predict future price fluctuations.
How do Bollinger Bands work?
As noted above, the indicator consists of three lines: one exponential moving average and two price channels above and below it. Price channels depend on price action, widening at the moments of high volatility and contracting when the market is still. Price bands are the standard deviations of the underlying asset and encompass the trading activity around the trend.
For investors volatility is as important as trend direction and trend strength: volatile markets provide additional trading opportunities. If you want to understand how to use Bollinger Bands in trading, then it’s important to understand they are based on one simple idea: when the price level rises/drops too much it is supposed to bounce back. It can also be noted that calm periods of low volatility are usually followed by serious market movements, which can also be predicted with the help of Bollinger Bands. All of the above can be used by traders to determine optimal entry points.
How to set up?
Setting up Bollinger Bands in the IQ Option platform is easy. In order to do so simply click on the “Indicators” button in the bottom left corner of the screen and pick “Bollinger Lines” from the list of available indicators.
Then click “Apply” if you prefer working with recommended settings. Otherwise, go to the “Set up & apply” tab and get an opportunity to adjust the period and the standard deviation according to your requirements.
The indicator is ready for use.
How to use Bollinger Bands in day trading?
In order to use Bollinger Bands effectively in day trading, it’s essential to understand basic characteristics of price volatility and its applications in trading.
As a rule, periods of low volatility are generally intermingled with high volatility periods. In the downtrend, the price usually fluctuates between the lower band and the average line. In the uptrend, on the contrary, the price lies in the corridor between the upper band and the middle line.
The longer the market stays still the higher are the chances for an upcoming volatility boost. Bollinger Bands are ideally suited to pinpoint such moments. Using this indicator the trader is able to predict future volatility fluctuations and determine overbought/oversold positions, opening deal at the most expedient moment.
When the asset leaves the “normal” price range the majority of risk-averse traders stop opening new deals and wait for the market to stabilize once again.
The situation when the price bands come closer together is called the squeeze. Such periods indicate low current volatility and potential for high volatility in the near future. However, the indicator doesn’t provide the trader with the information on a particular moment in time when volatility is supposed to increase. Traders remain mostly inactive during the squeeze.
Approximately 90% of price action takes place between the price bands. The events that take place in the remaining 10% of the time are called breakouts. A breakout is an event during which price action leaves the “normal” price range. They should not be used as trading signals as they do not provide any information on future trend strength and direction.
Combine and conquer
Bollinger Bands are good at showing current volatility and sometimes predicting upcoming market fluctuations but are not a universal trading tool. According to Mr. Bollinger himself, this indicator should be combined with other indicators for maximum predictive potential and effectiveness.
Bollinger Bands are an indicator worth learning and using in real-life trading. Not only it is simple and useful but also has a potential of giving the trader timely buy or sell signals, while the majority of market participants are still unaware of the future trend direction.
Buying the stock when the average line crosses below the lower Bollinger Band and selling it when the price has bounced from the upper Bollinger line is a widely used trading strategy with high profit-generating potential.