Bollinger Bands® are among the most reliable and potent trading indicators traders can choose from. Bollinger Bands® can be used to read market and trend strength, to time entries during range markets and to find potential market tops. Bollinger Bands® are a dynamic indicator which means that they adapt to changing market conditions and, thus, have benefits over other standard indicators which are often perceived as ‘lagging’. In this article, we show you how to use BBollinger Bands® to improve your chart reading skills and to identify high probability trade entries.
Bollinger Bands® explained
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 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. However, we suggest setting the Bollinger Bands® to 2.5 Standard Deviations to make them wider and capture more price action. With the 2.5 standard deviations, 99% of all price action falls between the two bands, which means that a violation of the outer bands becomes a much more meaningful signal as we will see.
Watch the video bottom how does Bollinger Bands® works inside the IQ Option.
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Trend-trading with the Bollinger Bands®
In contrast to most other indicators, the Bollinger Bands® are non-static indicators and they change their shape based on recent price action and accurately measure momentum and volatility. Thus, 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
A break of the moving average is often the signal that a trend is ending
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 – very bearish signal.
2) Price fails to reach the outer band and then shots up very strongly, even showing an engulfing pattern. This is a classic reversal pattern where the bearish trend strength faded.
3) 3 swing highs with lower highs. The first swing high reached the outer band whereas the following two failed – fading strength.
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.
Finding tops and bottoms with Bollinger Bands®
After setting your Bollinger Bands® to 2.5 standard deviations, you will see that price reaches the outer bands less often. At the same time, the meaning of such signals becomes much more important because it shows significant price extremes.
There are two types of tops that you need to know about:
1) After a trend move, price fails to reach the outer Band as the uptrend becomes weaker. This signal is usually accompanied by an RSI divergence >> Continuation signal
2) During a consolidation, price spikes into the outer Bollinger Bands® which get rejected immediately >> Reversal signal into the short direction.