Bollinger Bands are a technical indicator that measures volatility. They consists of a center line and two outer bands. As the price action becomes more volatile, the outer bands move away from the center line simple moving average, while constrict during less volatile times.
The centerline is a 20-day simple moving average. The outer bands are two Standard Deviations away from the centerline. Standard Deviation is a mathematical formula to measure volatility, so it works well for this type of indicator.
Most trading platforms do not show the centerline, because it may clutter your trading screen. The shape of the two outer bands are what define the Bollinger Band strategy. Joel uses the 20-day simple moving average, so you may see it on his charts.
Bollinger Bands Formula
You may see Bollinger Bands denoted in brackets
(20,2). The Period and Standard Deviation are set to 20 and 2, respectively.
Refer back to the Simple Moving Average formula for the first step. The past 20 candle closes are used and divided by the amount of candles.
candle_closes[1..20] / 20
The Standard Deviation is a little more tricky to understand. Mathsisfun.com has a great example of the Standard deviation formula. We’ll be using Excel, which has a Standard Deviation (
STDEV) function built in.
- Middle Band = 20-day simple moving average (SMA).
- Upper Band = 20-day SMA + (20-day Standard Deviation of price x 2).
- Lower Band = 20-day SMA – (20-day Standard Deviation of price x 2).
The spreadsheet below is a working example of Bollinger Bands with all formula calculations. For this example, AUD/CAD Daily price closes were used, based on the 22:00 GMT close. You could use the AVERAGE function, however this example splits the sum and division so it's clear.
Bollinger Bands Strategy
When a trader learns how to use Bollinger Bands, the first two concepts are identifying when a currency pair is overbought or oversold. If the price action touches:
- Upper band - considered to be overbought
- Lower band - considered to be oversold
In total, there are 22 rules that John Bollinger created when integrating Bollinger Bands as a trading system.
Joel recommends combining the Bollinger Bands with the RSI indicator. They complement one another very well. There are two types of tops that you need to know about:
- Reversal Signal - Price action spikes through the outer Bollinger Bands and immediately returns.
- Continuation signal - After a trend move, price action fails to reach the outer Bollinger Band as the trend becomes weaker. This signal is usually accompanied by an RSI divergence.
Bollinger Band Squeeze
If a currency pair has low volatility, the Bollinger Bands contract in size, which brings them closer to the centerline. As this happens, the price action is also squeezed. Often the Bollinger Band squeeze happens along with other technical indicators converging, so the price action shoots off like an elastic band when it breaks free of the consolidation area.
- Download John Bollinger’s 22 Bollinger Band Rules.
- It's helpful to use Bollinger Bands as part of your trading system, but do not make trading decisions on this indicator alone.
- Price action is usually confined within the Bollinger Bands. If it goes outside the bands, take note.
- Bollinger Bands work well with the RSI indicator.