The Bollinger bands are plotted with the help of three lines. The middle line is a moving average line that can be varied as per convenience (usually a 20-day moving average) and the two outer bands are two standard deviations away from the moving average line. These outer bands are calculated using a formula that uses recent price changes of the securities being analyzed.
The space between the outer bands helps in identifying the volatility in the market. The space between Bollinger bands widens when the volatility of the market is high. The outer lines of the Bollinger bands shrink when the market volatility is low. Traders can use this to assess market conditions and adjust their trading strategies accordingly.
How do Bollinger Bands work?
The outer and inner bands are created by calculating the moving average of an asset over a specific period and adding and subtracting a specific multiple of the standard deviation from the moving average.
The overbought and oversold conditions are identified using Bollinger Bands, to generate buy and sell signals, when the prices of securities touch the upper and lower bands. This ultimately Indicates that the security is due for a price correction or reversal.
How to trade with Bollinger Bands?
When the bands contract volatility is low and vice versa. The Bollinger squeeze looks for breakouts above/below the band depending on trend to be used as entry signs.
Highlighted in green shows these breakouts in an uptrend. Traders will look to enter at the indicated green circles. After each entry, it can be seen that the candles are ‘walking the Bollinger‘ (following the upper band). After the breakout candle the bands expand implying greater volatility in the market.
The black shaded circles illustrate the point at which traders will look to take profit before looking for further breakout signals.