# Part I. Bollinger Bands

Commander in Pips:
Today we start to study different indicators, how to apply them, their flaws and advantages – in other words all that will be important to you in trading. Indicators will become another tool in your trading arsenal. Application of different indicators will allow to you catch many specific nuances in price behavior and turn them in your favor.

The market environment could be different, so you need different tools to act in this environment accordingly. The more tools you have – the more effectively you can act, depending on the particular situation in the market. That’s why we will speak not about one, not two but about many indicators.

Another way how you can apply them – is to find out which one is most suitable for you and apply 1-2 indicators. Maybe this approach even preferable to that of using all sorts of indicators – we do not want to analyze spaghetti charts, right? Probably you may even be able to become an expert in moving averages or some other indicator sometime.

Hence, you can not use all of them in perspective, but you should have the possibility and understanding to choose from the tools available– that’s why we will take a look at number of indicators. But this is enough blah-blah-blah, let’s shift to the first indicator, that is called “Bollinger Bands”.

Pipruit: Finally. I was always interested in some lines that could be plotted in separate window on the chart. As it happens – they call Indicators! Finally I will understand what they are…​

Commander in Pips: Right, so –

Bollinger Bands

In the beginning of our discussion I want to give you the link: www.bollingerbands.com. We will not talk about formulas of Bollinger Bands (let’s call it BB), history of its creation, about Mr. Bollinger himself, etc. We will discuss only those parts that are really necessary for us – the practical application of this indicator. But the link will allow you to learn more, if you will wish that.

Description of BB Indicator

In general, BB consists of three lines – some MA in the middle, and two bands – an upper band and a lower band. The determinative parameter for BB is the period/type of MA, because bands are derivative lines from the MA parameter. The major value for trading of this indicator is in bands. If you are familiar a bit with probability theory and normal distribution – you will easily understand it, if not… Ok, I’ll try to explain it simply. Normal distribution suggests, that some variable – in our case this is price, will stay in a range of two standard deviations with a probability ~95%, in range of three standard deviations with a probability more than 99%. And this should happen during the period, based on which this standard deviation has been calculated.

Pipruit: What?​

Commander in Pips:
Ok, ok, I’ve got it… Look, let’s talk about parameters of BB indicator:

1. MA – period, its type and type of price – close, high, low, etc. That is what we’ve talked about in previous chapters, nothing is new here – the same parameters as for any MA;

2. Number of standard deviations. The greater this parameter – the wider band lines, and the less probable that market will touch it. In most cases there is not much sense to apply more than 3 standard deviations.

You will not have to calculate any probabilities, standard deviations itself and other stuff. Just keep in mind, that applying 2 deviations tells that price action will be inside the bands with probability 95%, 3 standard deviations – 99%. So, market will touch the bands very rarely.

Pipruit: And what is a major importance of this mind-cracking stuff?​

Commander in Pips: Very simple. Think and tell me – if applying of 3 deviations suggests, that price will have to remain between the bands with 99% probability, and market occasionally touches upper or lower band, what does it tell us?

Pipruit:
Hm, if market should stay inside the band range with 99%, and currently it at the band, well, I don’t know, may be it should return back – in the range between the bands?​

Commander in Pips:
Definitely. But this demands some clarification – it’s not so simple.

Pipruit:
Cool! And why it’s a big deal about the MA period?​

Commander in Pips:
The MA period has the same sense as in a simple MA. The longer the MA period – the more smooth and lazy these lines, and the lines of BB. Also they will be wider. In fact, this is the same sensitivity to most recent price action – if you appoint a short period, then bands of BB will be very sensitive to price behavior and looks like kinked curves. If you appoint greater period – the line will be smoother and bands range will be wider.

Pipruit:
And why is it in that way?​

Commander in Pips:
Because there is a direct correlation between deviation value and the period. Just to keep it simple – the greater the period, the greater the volatility and deviation. So as deviation is greater – the distance between bands is also wider.

Pipruit:
Ok, you’ve said – "applying 2 deviations tells that price action will be inside the bands with probability 95%, 3 standard deviations – 99%. So, market will touch the bands very rarely." So, this tells us that the market will stay in this range in the future. So, it means that I know ahead of time the market’s range, does it?​

Commander in Pips:
No.

Pipruit:
?​

Commander in Pips: Come on, think yourself, if it was so simple – everybody was a billionaire already. The detailed answer as follows – how it works in general (here is our “further clarification”):

1. The most recent point of the BB indicator in time and its bands shows the range, based on historical deviation that has been calculated based on last “N” candles, which you’ve specified as a MA parameter.

2. When the new bar has appeared – the most distant bar is eliminated from the calculation and replaced by the most recent bar. Due to this, the value of deviation changes, and it also makes the distance between bands change. The same as with any Moving Average calculation.

3. In general – if future price volatility will be less than those that has taken part in current calculation of deviations – then the market will stand inside the bands range. If it will be greater – then range will become wider. But you do not know ahead of time – will it be so, or not.

That’s why it is not so simple – to say that market should bounce to the downside, when it touches the band.

Pipruit: I see. But why we need this indicator at all, then, if volatility is changing over time, and we can’t be sure – will price bounce from the band or not?​

Commander in Pips: Reasonable question. I want to cheer up you a bit. First, the market very often stands in the range or does not show really impressive thrusts – very often it moves so-so. Although bands fluctuate all the time – the volatility does not change drastically, and BB becomes and excellent indicator – its bands hold price action very well. Even when this harmony suddenly breaks – it tells you something different, because it takes shape in bands behavior.

The second answer you know already – never rely on any single tool. Any indicator should be used only as addition to an overall strategy, but not as an overall strategy itself.

Pipruit:
Ok, I think that I catch it. Although, I do not understand your crabbed basis, why it works at all, but I understand the major point. BB was built on probability theory and based on some math law – price objectively couldn’t deviate for more than 2-3 standard deviations of price action during the period that we’ve specified in BB tunings menu if volatility of the market will not become greater.​

Commander in Pips:
Well, this is quite enough – nice explanation.

Pipruit:
So, how we could use it?​

Application of the Bollinger Bands Indicator

The BB indicator could be applied in some ways:

1. Estimation of market volatility. In general, when the market is calm and quiet – volatility decreases, hence deviation of price from its average also becomes less, and…?

Pipruit: (*we use 2 or 3 deviations…each deviation becomes smaller…*)… and the range between bands becomes tighter.
Commander in Pips: You’re right. Well done. At the same reasoning the distance between bands becomes greater, when the market turns in sloppy price action or in an impulse and thrusting move.

Here is how it looks like:

Chart #1 | AUD/USD Weekly, 20-period/2-deviations Bollinger Bands
Commander in Pips: Here you can see – when the market was calm – the distance between the lines was tighter. In 2007 market fluctuations became wider, hence, volatility was increased and the distance between BB bands then expanded. During the collapse in 2008, the market was really loud – the bands’ distance has become really wide.

Pipruit: Looks nice, but still, the market has pierced its lines …
Commander in Pips: Yes, partially it because of just 2 deviations application. Look, how it will be, if we apply 3 deviations:

Chart #2 | AUD/USD Weekly, 20-period/3-deviations Bollinger Bands
Pipruit: Oh, much better, you were right, Sir.
Commander in Pips: I even have had to eliminate some points, where market previously touched the bands. And here we get the second application way of Bollinger Bands – classic BB Bounce.

2. Classic bounce from Bollinger Bands lines

As we’ve noted already, due to math laws, price tends to return to the middle of the bands. According to normal distribution, when price reaches any of the bands – it becomes stretched, like a spring and tends to move right back. So, the bands of BB indicator acts like support and resistance:

Chart #3 | AUD/USD Weekly, 20-period/3-deviations Bollinger Bands

The longer the time frame is, the stronger these bands are. It’s a long time already the classic trading strategy exists, that based on application of BB Indicator, when market does not show real trend, or when this trend develops very smooth, without solid splashes. Other words – when volatility is constant or decreasing.

But the Bollinger Bands Indicator could be applied, when market does have a trend:

3. Bollinger Bands squeeze

This method works better when you give market more room for breathing by appointing just 2 deviations. Why? Because the market has 5 times greater probability to move outside the bands –5 % against ~ 1% when 3 deviations appointed.

Chart #4 | AUD/USD Weekly, 20-period/2-deviations Bollinger Bands
Here we can see that bands squeeze tightly and move almost parallel, range between them is stable. This is an early caution about potential breakout.

Pipruit: Why in the world?
Commander in Pips: Because, calm and very harmonic movement of bands and a tight range between them tell us, that volatility extremely stable. This couldn’t hold too long. Tight range between bands tells, in turn, that volatility is low. This combination tells, that market in extremely calm period - it couldn’t hold too long. Extreme calming is unnatural for markets and this could lead only to a single scenario – growth of volatility and breakout.

Pipruit: Tremendous. Thanks, sir.
Commander in Pips: So, when market shows a close below some band – this is the most probable direction of the breakout. Especially if it shows a number of closes in this direction. On our chart this is a close below the lower band – hence, we should expect breakout to the downside:

Chart #5 | AUD/USD Weekly, 20-period/2-deviations Bollinger Bands

Pipruit: Cool!
Commander in Pips: Yes. Well in general this approach could be used to identify the starting of new strong move as soon as possible. But, as you understand, you will not see such action very often.

Pipruit: And what time frames can we use for BB application?​

Commander in Pips: The most common approach to this is to use not just one but two MAs on the chart.
Pipruit: And what it could give us?​

Commander in Pips: Any. Do you write all of this stuff down? This is important. And now some additional advice:

1. If the market penetrates BB band and couldn’t reach the MA line – middle of the range between the bands, then it tells about power of the market in this direction and that the previous move has a solid odds to continue. Just look at chart #5 – market penetrates lower band, but was not able to return even to blue MA line. Then, the move down continues…;

2. BB bands, especially by applying 2.5-3 deviations and about 20-period could be used as an indicator of overbought/oversold levels and conditions on the market. When the market touches the upper band – the market is overbought, when it touches the lower one – oversold. It is preferable to apply this method not lower than on the daily time frame. A combination of Oversold+ Fib support or Overbought + Fib Resistance has a greater probability to stop the market for some time.

3. BB bands could save you from unwelcome areas to enter the market. It’s safer to buy in the lower half of the range, and Sell in the higher half of the range. Also avoid entering the market, when it stands at the bands – long at higher band, and short at lower band. Because, as we’ve said already – there is a high probability of bouncing in the middle of the range.

4. As with any other indicator, BB demands fine tuning, by analyzing its application with different pairs and time frames. You should find parameters that most suitable for your trading style and pairs that you trade.

5. You may apply different variations of the tools that I’ve pointed out. For instance – I said “if the market shows close outside of some band”. You instead could apply not one but 2 or 3 closes. The akin variations are allowed in other strategies with BB. Be free to experiment with the parameters you use, confirmation signals and other things! Your task is to find out how to make more pips on the market. And there is nothing forbidden with any indicator. If something is dangerous– I’ll definitely warn you.

Look, how these points could be used:

Chart #6 | EUR/USD Daily, 20-period/2.5-deviations Bollinger Bands and Fibonacci tools
At the first touch of 0.382 support market was oversold at the same time – so price was really stretched here, and it was very hard to it continue move down – the market has got some relief and pulled back. During the second touch – the market has pierced the 0.382 level, but only due the target from AB-CD pattern that was slightly lower – precisely of the daily oversold again due to the lower BB Band – and the market just jumped up as an arrow from a bow.

Here also we can see as example – what happens, when price just creeps with bands. Look at previous move up on chart #6 – see, price drift right with the upper band and doesn’t pull back into the middle. It tells is that further upwards move should continue, and the market is really strong. That we can see on this chart…

Pipruit: The last chart is outstanding. So many tools were applied there, and so consistently. Amazing… Now I become to better understand what you mean when telling to use different tools in combination.​

Commander in Pips: I’m glad that you are satisfied with that – but later I will tell you about another indicator that is more suitable for overbought/oversold estimation, to my mind. So, let’s shift to the next indicator.

A
Amanda_pips
12 years ago,
Registered user
How many deviations shoul i use at my trades?
Sive Morten
12 years ago,
Registered user
> How many deviations shoul i use at my trades?

Hello Amanda,
well, using 3 deviations gives rarer signals but more reliable, while 2 deviations will give you possibility to trade oftener, but signal safety is lower. Choose what you like more.
Hamza Samiullah
6 years ago,
Registered user
Longer one..
O
One-fm
5 years ago,
Registered user
Nice combination!