Understanding Bollinger Bands as a volatility and momentum tool is probably the best way of using this indicator professionally.

Bollinger Bands is a kind of technical indicator that is widely used by many traders across various markets such as futures, currencies, and stocks. Bollinger Bands provide traders with distinct insights into price and volatility which makes it a useful tool for determining the entry and exit points of trades. The tool can also be used to follow trends, determine overbought and oversold levels, and monitor breakouts.

Due to the simplicity of this trading tool, it is quite popular with almost all kinds of traders including professional ones. Let us now examine Bollinger Bands in detail and why professional traders take a liking to it. The Bollinger Bands essentially consist of three parts:

  1. A Simple Moving Average (SMA).
  2. An upper band above the SMA (positive standard deviation).
  3. A lower band below the SMA (negative standard deviation).

A standard Moving Average plots a set of average prices that produces a price action line that is continuous and even but Bollinger Bands takes this a step further by integrating standard deviations so that the observation of price action is done within a channel-like tunnel.

Bollinger Bands

Another unique feature of Bollinger Bands is their incredible flexibility. They are dynamic as a result of their ability to adjust to various market conditions thus making it possible for them to be used in trading several financial assets. This only goes to increase their usage and popularity among traders, especially professional traders. Bollinger Bands involve some calculations which are quite straightforward and are shown below:

  • Middle band = 20-day Simple Moving Average
  • Lower band = (20-day standard deviation of price x 2) + 20-day SMA
  • Upper band = 20-day SMA – (20-day standard deviation of price x 2)

For Bollinger Bands calculation in general, the SMA is obtained by the sum of closing prices over n periods / by n which in this case is 20 days.

 

Using Bollinger Bands the Professional Way

Bollinger Bands is a powerful indicator that provides traders with several trading signals that professional traders use as a volatility channel and a momentum tool. When used as a volatility channel, traders observe the upper and lower bands for signals of volatility in the market. One of such signals is the Bollinger Bands squeeze which is seen when the upper and lower bands converge, particularly after a trending period.

Bollinger Bands squeeze is also known as contraction and it indicates that the underlying market is undergoing low volatility. Usually, periods of low volatility tend to be followed by a period of high volatility which presents traders with a lucrative opportunity to capture large profits from the resulting price move. Therefore, a squeeze is a period of price consolidation before a breakout.

Bollinger Bands Squeeze

When high volatility occurs in the market, there will be a divergence between the upper and lower bands of the Bollinger Bands. In such a case, one of two things will happen. Either there is a bullish breakout in the market (an indication of a buying opportunity) which is confirmed by the breach of the upper band, or there is a bearish breakout (an indication of a selling opportunity) which is validated when the lower band is breached. Using Bollinger Bands to trade breakouts is highly effective due to the risk/reward opportunity. Usually, a tighter squeeze tends to result in a stronger breakout.

When the Bollinger Bands is used as a momentum tool, traders utilize it for the identification of overbought and oversold conditions in the market. This is possible because Bollinger Bands incorporate standard deviation in its calculation thus allowing traders to apply the concept of mean reversion in trading. Mean reversion theorizes that the price of an asset is more likely to revert to its average price over time.

Mean reversion is quite effective for trading ranging markets since the upper and lower bands function as dynamic lines of resistance and support respectively. This way, traders will endeavor to trigger buy orders when prices are at or near the lower band while sell orders will be initiated when prices are at or near the upper band.

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Bollinger Bands are undoubtedly effective. But even then, the information they provide can be 'bare' sometimes which is why professional traders pair them up with the trade signals provided by the MACD or RSI; indicators that display the strength and momentum of a trend at the value price areas.