The Bollinger Bands Indicator (BBI) refers to a unique type of indicators, combining trend and oscillator indicators, sometimes called volatility indicator. Bollinger Bands consists of three curves, drawn along the price. The Middle band is simple MA. Upper and Lower Bands stands for the possible amplitude of oscillation.
The purpose of Bollinger Bands is to show relative highs and lows of the price. By definition, prices are high at the upper band and low at the lower band. According to standard inputs and principle of calculation of the indicator, the upper and lower boundaries are shifted from the average (SMA) price for a distance of double standard deviation. Basically, to cross one of the bands, a price has to overcome two standard deviations, calculated for the chosen period.
John Bollinger created Bollinger Bands indicator in the 1980s as well as a term trademarked by him in 2011. His approach came from the understanding that volatility was dynamic, not static as was widely believed at the time. J. Bollinger has a website where he presents information about BB Indicator itself, it trading strategies and patterns: http://www.bollingerbands.com/
Bollinger bands consist of the three lines, the Middle line, Bottom line, Top line.. The Middle line (ML) is a usual Moving Average of the price (SMA).
ML = SUM [CLOSE, N]/N;
The top line, TL, is the same as the middle line a certain number of standard deviations (D) higher than the ML.
TL = ML + (D*StdDev);
The bottom line (BL) is the middle line shifted down by the same number of standard deviations.
BL = ML — (D*StdDev);
N — is the number of periods used in the calculation.
SMA — Simple Moving Average.
StdDev — means Standard Deviation.
StdDev = SQRT(SUM[(CLOSE — SMA(CLOSE, N))^2, N]/N);
It is recommended to use 20-period Simple Moving Average as the middle line, and plot top and bottom lines two standard deviations away from it. Besides, moving averages of less than ten periods are of little effect.
How to use it
There are numerous patterns and trading signals, which can be identified with this indicator. Let’s look at the most popular techniques and trading principles.
Bollinger Bands crossings
The simplest signals are price crossing of the bands. Higher band is crossing – Sell signal. Lower band crossing – Buy signal.
Bollinger Bands crossings + Candle patterns
As we see on Bollinger Bands crossings, simple Bollinger Bands by itself generates a lot of false signals. Thus there are proven techniques to confirm BB crossings signals. One of them is Candle patterns. There are many patterns, some of them portend a reversal in price, some continuation of a trend. To sum up, we seek for particular candle formations when the price is located near the extremums of the indicator, to determine whether the price will unfold or the trend will remain. Basically, we do not wait until the price crosses the Bands, we wait until the price forms one of the known patterns, then we will make a decision.
Bollinger Bands + Price Patterns
There are many articles and works around the net about Arthur Merrill patterns (M&W patterns). Bollinger bands indicator often used to clarify turning points for M&W patterns. Also, You can find information about M&W patterns here: http://www.bollingeronbollingerbands.com/patterns/
Consider the construction of two main patterns: M Top and W Bottom.
- Price breaks to the upside and rides along the upper band in a classic breakout fashion
- After making a bit of a pic, price pulls back
- The price forms another high, but this time, it is not riding along the upper band. It makes another top but does not cross the band.
The W bottom has the same concept as the M Top only in reverse. As it looks, the price makes a double bottom, but knowing the second bottom is well within the Bollinger bands gives confidence that the momentum and volatility support a reversal.