What are Bollinger Bands - Trading Strategy, Indicator, & How to use
Wondering how to determine entry and exit points while trading? You can use bollinger bands. In this video from the #LearnWithUpstox series we’ve explained how you can use Bollinger Bands on Upstox easily.
Welcome back to a new blog of ‘Learn with Upstox’. Today we will read about Bollinger Bands.
Invented by a gentleman called John Bollinger, to precisely define over-sold and over-bought trading areas, ‘Bollinger Bands’ is one of the most famous indicators used for investing, trading, short-term trading and mid-term trading by both traders and investors.
In my previous blog, moving averages, we spoke about Simple Moving Average. Let's say we plot 20 SMA on a line. Standard deviation is the measure of the amount of variation of a set of data from its mean. Now with this in mind, let us look at the Bollinger band.
The upper line in the image depicts the upper band or upper envelope. The middle band depicts the moving average. The lower band or envelope depicts the standard deviations. These are important as they help us predict support-resistance level. But again, what is a Bollinger Band?
The Use of Bollinger Bands from the Investor’s Perspective:
For an investor, there’s nothing more crucial than the lowest points in the market. Bollinger Bands tells you precisely that. All you need to do is set the standard deviation right. For instance, if you set it to 1, there is a 65% chance that the price will stay inside the bands and you might get to make less-precise assumptions, with less reliable signals. On 2, there’s a 95% chance that the price will stay inside the bands, promising you more accuracy. At 3, the greater range promises 99% chance of the price staying inside the bands. At 1, you get more frequent signals but less accuracy, whereas on standard deviation 3, you’re promised 99% accuracy but less frequent signals, which means they are reliable. I personally prefer keeping it at 2.
Let’s look at a monthly time frame. The standard deviation here is set at 2. The lower band is an oversold zone which gives value buying, while the upper band tells you the target buying. This data is from 2006 – 2021. The middle band acts like a support-resistance. When the stock or index hits the lower band, it creates a buying opportunity. A good buyer tries to accumulate stock for the long-term, hence, doing it on dips. In this example, I’m thinking you are an investor and holding this, while a trader may not. As you can see, this stock gave buyers six opportunities in ten years. So if you are investing, buy when it is in the value buying (low) zone for the long-term.
The Use of Bollinger Bands from the Trader’s Perspective:
For a trader, there’s nothing more satisfying than a timely and useful trading tip. In swing trading, the bands give the trader the leverage to follow the trend efficiently. In the previous example, for long-term we were buying at value points and selling at high points. In Swing trading, we follow the trend with Bollinger bands. For this, Bollinger bands are not enough, and you will need to apply other indicators, so be careful. So, before you initiate buy or sell, you have to first understand the trend. Buy in an uptrend, sell in a downtrend.
In this graph, first we have a downtrend, then sideways, but after that we see high points. When we see high and high points and low and high points, we are in an uptrend. This is an hour-long timeframe, which means it’s good enough to confirm for a trader. After this, you can buy, but in the support field. Here our middle band and lower band will behave as the support. This will help you make a few wins. But in trade, nothing is 100%. So, as a trader, you have to accept a few losses, but follow a win ratio and risk management system. Once the second high is smaller than the first high and the second low is lower than the first low, it is time to start selling.
Now, talking about a smaller time frame, it is tough to judge the market in a shorter time frame on the basis of Bollinger Bands. One strategy from Upstox, lookout for the ‘Squeeze pattern’ on the Bands. This is when there is a squeeze from the underneath as well as the top. This keeps happening, not within minutes but every 2 – 4 days or weeks. When you see it, remember you’re looking at a promising trading opportunity. Looking at the image below, you will see various types of squeeze patterns that I have marked with my rectangles. The longer the squeeze, the bigger the target it promises. Just make sure you make the trade in the direction of the breakout. To achieve your targets using the Bollinger Bands, Squeeze is touted to be one of the best strategies.
Bollinger bands squeeze when the price consolidates or moves sideways. Nevertheless, it is advisable that while trading one must apply other indicators as well and not rely on Bollinger’s Bands or any one of the indicators, entirely. The thing is, before you buy or sell, you take your time and you understand the trend.