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The Bollinger Bands is a trading indicator created by John Bollinger which consists of three lines; the upper band, the lower band, and the Middle band. It gives traders opportunities to properly identify when an asset is overbought or oversold.
Figure 1: the Bollinger bands denoting the upper band, the lower band, and the middle band
So, the Bollinger Bands is made up of three components; the Upper band, the middle band, and the lower band. The position of the upper bands and the lower bands are on either side of the middle band (20 period MA)
- Identify overbought or oversold areas
- Identify the volatility of the market
- When the price of a trading instrument crosses the upper band, it denotes an overbought market. This is a selling opportunity (short).
- When the price of a trading instrument crosses below the lower band, it denotes an oversold market. This is a buying opportunity.
Figure 2: the Bollinger bands denoting the buy and sell opportunity
- The Squeeze: when the upper band and the lower band contract, it signifies low volatility. This is known as the Bollinger squeeze and it is considered by traders to be a sign of future increased volatility and likely trading opportunities.
- The Bollinger Expansion: when the upper band and the lower band expand, it signifies increased volatility. It is considered by traders to be a sign of a future chance of a decrease in volatility.
Figure 3: the Bollinger bands identifying market volatility
The Bollinger Bands has been a useful tool by the technical traders. However, it came with a few limitations that traders should put into consideration before its usage.
- The bands are built primarily to be reactive, not predictive. So basically, the bands react to changes in the movement of price either in an uptrend or downtrend. Therefore, like other technical indicators, it is a lagging indicator due to the fact that it relies on a simple moving average by taking the average price of several price bars. According to John Bollinger, it is advisable to “use the system along with two or three non-correlated tools that provide more direct market signals.
- The standard settings vary with traders. Therefore, it is advisable for traders to use settings that suits into the trading instrument or their market structure.