Adding Bollinger Bands to your technical analysis toolkit

  • By Noah Schumacher

  • May 9, 2021
  • 1:58 am BST

Experienced CFD traders tend to assemble a toolkit of go-to technical indicators. Any one of these indicators can be useful, but they can be far from infallible in isolation, so using several together is a strategy that many successful traders adopt. If you have not yet added Bollinger Bands to your trading toolkit, then here are a few tips that you might want to know about this particular indicator.

Bollinger Bands are a technical indicator developed by market technician John Bollinger. As far back as the 1980s, Bollinger developed his technique of monitoring price movement by using a moving average, with two bands inserted on either side of that moving average. The aim of this technique is to help traders make decisions on when to open and close their positions by measuring market volatility and predicting price movement. Bollinger Bands have much in common with other tools that use a moving average, but as with most technical indicators, the tool has its own unique features that some traders love and some do not.

Bollinger Bands can monitor the price movement of any asset in any market and are widely popular in many different types of trading, including CFD trading and forex trading. The bands create a strong picture of market volatility. When the market is relatively quiet and stable, then the bands are close together. When price movement occurs, they start to spread further apart.

This technical indicator works using a standard deviation formula and shows how far an asset’s price is moving away from its true value in either direction. CFD traders can find a wealth of price data in the small gap between the two bands. In very simple terms, if an asset’s price is consistently touching the upper band, then it is generally overbought. If it is consistently touching the lower band, then it is probably oversold.

In an uptrend, prices tend to stay in the gap between the moving average and the upper band. If they dip below the moving average line, then this indicates a trend reversal. Likewise, in a downward trending market, you will see prices between the moving average and the lower band, with a rise past the moving average line also showing a trend reversal. Because the bands are showing standard deviations in the price of a particular asset, the distance between the bands is important. Close bands indicate that the market is in a tight trading pattern with low volatility and little price movement going on. Wider, spread-out bands show more price action, increased market volatility and more opportunities for traders. As the bands expand and contract, it makes it very easy for traders to monitor trends over time.

As is the case with any technical indicator, Bollinger Bands are not a magic wand that will enable you to take profits easily. They are simply a clear visual indicator of market trends. How individual traders use this information will very much depend on their own trading strategies and how conservative or aggressive they are.

Risk-averse traders will often trade within the bands, choosing to enter and close their positions when prices are close to the upper and lower bands. This is not, however, the only way to use Bollinger Bands. A price hitting the upper (or lower) band is not necessarily a sell (or buy) signal. Sometimes, a price can trend well outside the limits of the bands, and more aggressive traders will tend to “ride the bands,” holding their position as a price rises well above the upper band and hoping for a bigger profit.

You will hear traders referring to something called the Bollinger bounce. This can, but does not always, happen when a price hits one of the bands. The bands are measuring how far the price is deviating from an asset’s true value, so the price should always return to the middle of the bands. Often, the price will seem to “bounce” back up (or down) when it hits the bottom (or top) band, and traders tend to develop strategies to capitalise on these bounces, particularly in a ranging market.

Traders also refer to the Bollinger squeeze. This is, unsurprisingly, when the bands squeeze close together. As already mentioned, tight, close bands indicate that the market is currently calm and stable with little price movement, but as many experienced traders know, there is usually calm before a storm, and a period of low volatility can be a sign of an imminent breakout in price. Smart traders will be monitoring the Bollinger squeeze, aware that if prices break out through the top band, then this may be the first sign of a strong upward trend, just as a breakout through the lower band can be a sign that prices are about to trend downwards. It is not unusual for strong upward or downward trends to follow the Bollinger squeeze. Again, this needs monitoring. Sometimes, the market does not start trending at this point but returns to a ranging pattern, where you will start to see the Bollinger bounce again as prices range predictably between the upper and lower bands, and trading strategies will have to adapt to that ranging market.

Are there disadvantages to Bollinger Bands?

The disadvantages of Bollinger Bands are like the drawbacks of any technical indicators. They are just indicators and can, of course, give false signals from time to time. It is important that traders learn to conduct real technical analysis by combining various indicators to build a more accurate picture of what is happening in the markets. It is best to combine Bollinger Bands with indicators such as P&F targets and Fibonacci retracement levels. If you are looking to build a toolkit of technical indicators that complement your trading strategies and objectives, then check out our extensive range of articles on technical analysis.