A good indicator can be the confirmation a trader needs to supplement their trading strategy. Technical indicators such as Bollinger Bands gather data and information that help traders make trading decisions on entry and exit points when combined with a trading plan and other tools. Learning how to use Bollinger Bands in Day Trading properly is important for many profitable traders.
When you have a trading method and other indicators that contain information that “agrees”, you have confluence. It is just what a good trader requires, determining the market environment.
Depending on what you desire to measure, indicators supply technical analysis needed to seek out price movement, buying pressure, sideways markets, high or low volatility, and overbought or oversold conditions, just to name a few!
In this article, we will discuss one of the most used technical analysis indicators called Bollinger Bands. By the end, you will know what they are, what they measure, and how to use their information.
What Are Bollinger Bands?
Bollinger Bands were developed by John Bollinger in the 1980s. They are a technical analysis tool that can be used to determine the overbought and oversold conditions of an underlying asset.
It is important to note that the indicator isn’t meant to provide trading signals on its own. Matter of fact, John Bollinger has 22 rules he uses when using the bands as a trading system!
Bollinger Bands are a great volatility indicator, providing information regarding price movement. The Bollinger Bands indicator is devised of three trend lines which are an upper band, middle band, and lower band.
The upper and lower bands are two standard deviations of average variance, positive and negative, from the middle band. Standard deviation is the mathematic measurement of how outspread numbers are from an average price.
The middle line is a simple moving average. While the 20-day SMA is the standard moving average most commonly used for the middle band, the bands can be adjusted to a day trader’s preference given the asset and time frame they trade.
There is a mathematical equation to figure out the 20-day SMA, the upper and lower bands’ standard deviations, which make up the Bollinger Bands. It looks intimidating, but beginners desiring to use the technical indicator need not worry about the math. Like experienced traders, novice investors just need to know that the study is available on most trading platforms and can be customized to their trading style.
What Do Bollinger Bands Measure?
Again, the Bollinger Bands indicator does not produce enough confirmation on its own to recommend using it for buy and sell signals. It should be used with other technical tools that correlate.
The tool is measuring volatility, providing helpful information regarding market price movements. Bollinger Bands identify prices that have deviated from the average price.
The vast majority of price movement will be within the envelope of the bands. Now and then the price data goes outside the upper Bollinger Band and lower Bollinger Band.
The concept of the bands is that the market is more overbought when price action is near the upper Bollinger Band. The market appears more oversold when the price hits the lower Bollinger Band.
The bands widen when the market is volatile, price is swinging up and down. The band’s contract during low volatility, demonstrating smaller price action.
Using Bollinger Bands
When you can see market volatility and periods of price consolidation, trading opportunities emerge naturally. There are several ways to utilize Bollinger Bands information. We will cover a couple to give you an idea of the possibilities.
The squeeze strategy of the Bollinger Bands aims to take advantage of price movement after a period of low volatility and identify a possible future breakout.
The upper and lower bands contract and get closer to the middle band, demonstrating less market volatility and price action occurring. After such consolidation, a breakout can be expected.
When volatility increases, the sideways market will then end. The bands will start widening and day traders will see sharp price movements either up or down and take advantage of the action.
Mean Reversion Strategy
When used with other correlated tools, such as the MACD or RSI, traders can take advantage of when the value has perhaps fallen too low, and the price hits the lower Bollinger Band and bounces or moves to the upper band. The opposite can be true when the price has risen possibly too high, hitting the upper band and will eventually bounce or fall to the lower band.
This concept takes advantage of mean reversion when the market appears to be overbought and oversold. The idea behind mean reversion is that if the price moves substantially from the average, it will eventually pull back to the average or mean price. This strategy works well in range-bound markets when the price is bouncing between the upper band and lower band.
Important to Note
Using the squeeze or mean reversion strategies can identify possible buy and sell opportunities for day traders. It is important to note that the bands can give false signals, and it is crucial to consider trend direction to implement risk management.
For instance, when you have a trending market that is bullish, going up, taking only trade signals from the price movements hitting the lower Bollinger Band is advisable. A trader may see exit points as the price hits the upper band.
Considering strong trend direction and using the Bollinger Bands indicator with other tools that correlate will increase the effectiveness of the information being presented.
Summary: Bollinger Bands
Bollinger Bands are considered a lagging indicator because their information reacts after the price has moved. Despite such, they can be a highly effective technical indicator when combined with other personal trading strategies.
After price consolidation, pressure can build, and breakouts can be anticipated. Bollinger Bands can also tell a trader when the price has deviated far from the moving average and appears to be too high or too low.
Trading involves significant risk, so take the time to practice, practice, and practice!
Test technical indicators when introducing their information to your trading strategy. Get comfortable with the asset you desire to trade. See what works best with the strategy and/or technical indicators you have chosen to use, and on what time frames they are most reliable.
Resources to Check Out
YouTube video: The Right Way to Trade Bollinger Bands by MoneyShow
To Learn More
Maurice Kenny has helped over 600 people become financially free through one-on-one coaching, mentorship, and options trading strategy. Many of these new traders are now full-time traders, and they all started by watching his 1-hr webinar.
Feel free to check out other FREE educational resources to help guide you as you begin your new journey to financial freedom.
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