There is a famous saying that periods of unhappiness are always followed by periods of happiness and vice versa. Similarly in trading, periods of high volatility are always’!’ followed by periods of less volatility and again by periods of high volatility. We have to always remember that trading is a game of probability, the more sure we can become about the move the more successful would be our chance at it. Bollinger Bands is one more tool I would recommend you to master and use in conjunction with the others.
This metric, developed by John Bollinger, helps traders identify and mark periods of short term volatility. In technical terms volatility is defined by standard deviation, hence the period of volatility is graphically depicted by 3 lines: Upper band & Lower band enclosing the middle baseline.
Familiarizing the indicator on the chart:
1. On the tooling chart draw Bollinger Bands (by turning the indicator ON)
2. Three lines would be displayed on the screen:
- Middle Base Line: Simple Moving Average (SMA), usually of 20 past period (average value of average prices of the selected period)
- Upper Band: 2 standard deviations above the middle base line
- Lower Band: 2 standard deviations below the middle base line
3. Activate Bollinger Band Width (BBW): this will give the percentage of the band in terms of price:
- Lower Value of BBW: a period of contraction or low volatility, get ready to enter into a trade position
- Higher Value of BBW: a period of expansion or high volatility, get ready to close an already open trade position
Squeezing the Bollinger Bands
In the period of low volatility both the upper and lower band will come closer to the middle base line, compressing the moving average and this is called a squeeze (or a period of contraction). This squeeze is followed by a period of high volatility, it may be in either direction - mooning or tanking. In the case of mooning one has to enter in a long position and if the ticker is tanking then the trader has to enter in a short position.
On the contrary, when the upper and lower bands move away from the middle baseline, indicating a period of high volatility (or a period of expansion), the trader has to close the position (Closing the long position for upward price action and closing the short position for downward price action)
A very high percentage of price action happens between the upper & lower bands, but whenever it doesn't happen there is a breakout. Breakout imminently doesn’t imply the run of price action. It may or may not lead to correct direction. Breakout should be viewed as a signal to enter in a trading position, but with utmost caution. Breakout above the upper band signals upward price action, and below the lower band signals downward price action.
- Middle Base Line (MBL) = SMA (CAP, n)
- BUB (Bollinger Upper Band) = MBL + m*σ [CAP,n]
- BLB (Bollinger Lower Band) = MBL - m*σ [CAP,n]
- BBW (Bollinger Band Width) = (BUB- BLB)/MBL
- SMA = Simple Moving Average
- CAP (Candle Average Price) = (Open + High + Low + Close)/4
- n= no of past candles
- m= no. of standard deviations (generally 2)
- σ [CAP,n] = Standard Deviation over last n periods of CAP
Word of Caution:
Bollinger Band gives only price volatility information, to use this as a standalone metric without other indicators would be foolishness and hazardous.
Squeeze the Bollinger Bands to identify the right price to enter in a call, ride the wave and get out before the next squeeze happens. Do not ride alone, take help of RSI & EMA to have a smoother bump free ride.
- Always use Bollinger Band together with other indicators
- When upper and lower bands come closer to the middle line squeeze happens and this is a period of low volatility
- Price action is mostly between the upper and lower bands
- A breakout would happen and it may result in upward or downward price movement
- In case breakout happens above the upper band, upward price action may happen, go for a long position
- In case breakout happens below the lower band, downward price action may happen, go for a short position
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