Bollinger Bands are a well-known trend indicator in the retail trading community, made out of three “bands” that contain the price action. Developed by John Bollinger, these bands aim to identify trending conditions. However, these bands also have a volatility component, in the sense that savvy investors can use them to spot breakouts long before they happen. In this lesson, we’ll look at both approaches and discuss the advantages and disadvantages of trading with the Bollinger Bands indicator.
Bollinger Bands as a Trend Indicator
This indicator was designed to give investors the opportunity to find great entries during a trend. The indicator has three bands or elements called:
- UBB – Upper Bollinger Band
- LBB – Lower Bollinger Band
- MBB – Middle Bollinger Band
Like any trend indicator, the Bollinger Bands are applied to the actual price. The idea is to make a trend visible and, if the price remains contained within the bands, a trend is confirmed.
Here’s the definition of a bullish or bearish trend with the Bollinger Bands indicator:
- In a strong bullish trend, the price stays in the upper side of the channel (between the MBB and UBB); investors use the dips into the MBB to open long trades.
- In a bearish trend, the price remains in the lower side of the channel (between the MBB and the LBB); investors use the spikes into the MBB to open short trades.
The MBB is typically a Moving Average. The default settings of the indicator use the SMA (Simple Moving Average) for the MBB, but many investors favour the EMA (Exponential Moving Average) simply because it stays closer to the price.
The chart above shows two potential entries on the short side. The price hits the MBB, and the target is the LBB.
One problem for investors with the standard approach is where to place the stop loss. As there is no easy way to find a good risk-reward ratio (one larger than 1:2), investors often use reversal patterns into the MBB, provided by Japanese candlesticks techniques (Hammers and Shooting Stars, Morning and Evening Stars, Doji candles, Dark-cloud Covers, Piercings, etc.).
Bollinger Bands to Spot Breakouts
Typically, the currency market spends most of the time in consolidation. While trends do appear more often than in other markets, they appear mostly within smaller timeframes. For this reason, long periods of consolidation appear on every chart. This is where the Bollinger Bands’ UBB and LBB indicators come into play; they allow investors to spot a breakout.
When the two bands narrow more than normal, a breakout is expected. This strategy requires patience, as a new trend is only signified when the price closes below the LBB or above the UBB.
- Bollinger Bands indicators have three lines.
- The MBB is either an SMA (Simple Moving Average) or EMA (Exponential Moving Average).
- Bollinger Bands act as a trend indicator and they are also used to spot breakouts.
- Investors use Japanese reversal patterns in the MBB to find good risk-reward ratios.