Bollinger Bands are a technical indicator created by John Bollinger, which appear directly on a price chart (called an “overlay”). Typically three lines are shown; a moving average and then a lower and upper band. This creates the appearance of the price moving within an envelope, and the envelope widens during times of volatility and contracts during sedate markets. Bollinger Bands have multiple uses, including forecasting volatility, reversals, trend continuations and profit targets.
Figure 1 shows Bollinger Bands applied to a 15 minute USD/CAD chart. The middle line is a 20 period moving average, and the outer bands are always two standard deviations away from the moving average.
As volatility increases, this makes the standard deviation larger and therefore the bands expand. When the market is quiet, the bands contract since the standard deviation gets smaller. The actual calculations for the indicator are beyond the scope of this article, yet it is important to understand that Bollinger Bands expand and contract with volatility or lack of it, respectively. It is this feature which makes Bollinger Bands more useful than other “envelope” type trading indicators.
John Bollinger recommends 20 periods for the moving average, and 2 standard deviations for the outer bands. Traders can alter these settings to suit their own strategies or market, but Bollinger did note that using less than 10 periods is not likely to work well.
Apply Bollinger Bands to your chart, and you’ll notice that most of the time the price stays between the upper and lower band. Approximately 95% of the price data will occur inside the bands. Since so much price movement occurs within the bands, when the price touches or moves outside a band, it’s potentially a noteworthy event and may provide some insight into what the price will do next.
Mr. Bollinger made several observations about Bollinger Bands. Of those observations I find two of them the most intriguing; below I discuss these two observations as well as personal trading methods for how to utilize the observations in the real world.
1. A sharp price movement tends to come after the bands have tightened significantly. When the bands tighten it means that the price is being contained to a very small range, and that condition can’t last forever. When Bollinger Bands tighten, it is means the price is being compressed like a spring. While this condition may last for some time, when the price eventually breaks out, it’s typically an aggressive move.
When trading, mark the high and low of the price range. This will likely be similar to the Bollinger Bands levels. When the price moves above the high of the range and penetrates the upper Bollinger Band, go long/buy calls. When the price drops below the low of the range and penetrates the lower Bollinger Band, go short/buy puts.
If trading options, make the trade for a multiple of the chart time frame you’re watching. If the price breakouts out on a 15 minute chart, the binary option trade should ideally expire within the next 15 minutes, or 3 to 4 bars after the breakout (45 to 60 minutes) as this allows for a pullback and then another move in the breakout direction. If trading an hourly chart, the binary option should expire within the next hour, or the next three to four hours.
2. A move that originates at one band tends to go all the way to the other band. This method is useful for trading purposes. For example, if the price bounces off the lower band (even if it penetrated it) and then starts moving back toward the upper band, assume that the price will move close to the upper band. If the price bounces off the upper bands and then starts to move back toward the lower band, assume the price will move close to the lower band.
Since the price generally stays within the band, you’re watching for a reversal close to a band, and not necessarily exactly at it. The price may stop just short of the band, or pierce it. What matters is that the price gets close to a band, and then starts to move back toward the other band.
If trading an all-or-nothing binary option, buy puts when the price begins to fall away from the upper band. Buy calls when the price begins to rise off the lower band. Estimate how long it will take for the price to reach the middle (moving average) line, and then use that estimate as your expiry. For example, if you’re watching a 15 minute chart, and it typically takes 12 bars (180 minutes) to move from the upper band to lower band, then choose an option expiry of roughly half that, or 90 mins.
Since the tendency is for the price to move from one outer band to the other outer band, is even more likely that the price will at least move to the moving average line after bouncing off an outer band. This is why my price/time target is the middle line, and not the other outer band.
I prefer using this method when the price is moving in an overall sideways direction. When a strong trend develops, for example a downtrend, it is very possible to have multiple losing trades in a row when buying calls as the price bounces off the lower band. Therefore, avoid trading against the trend.
Bollinger Bands are a useful tool, although adding a personal touch is often needed to make the general observations useful in actual trading. No indicator is perfect, but if you utilize price trends as well as monitor Bollinger Bands, hopefully you can find yourself more often in-the-money. When trading options, timing is crucial. You can get excellent entry signals, but if the timing is wrong it’s all for not. Therefore, take some time to practice the timing methods discussed so your options are expiring at a favorable time for the strategy employed.