Bollinger Bands® are a trading indicator that display measured volatility by tightening around a financial instrument if volatility is low and widening if high. Visually, Bollinger Bands® surround a financial instrument with an upper and lower band with a 21 day moving average (preferred period of time) in between the two bands.
Bollinger Bands® can also serve as an indicator of overbought (tighter) and oversold (wider) market conditions.
Perspectives on Bollinger Band® Indications
- The tighter the bands are around a financial instrument, the more likely the financial instrument is to make a significant move to the up or downside in the near future
- The wider the bands are around a financial instrument, the less likely the financial instrument is to move significantly to the up or downside in the near future.
- Both Bollinger Band® indications of volatility, tight and wide, can be viewed as counter indicators due to using current market conditions to indicate a different, future market move.
Given the above, the optimal environment for using Bollinger Bands® is during periods of low volatility when price fluctuation is minimal. The technical indicator will constrict the longer the financial instrument remains stable in value. When the Bollinger Bands® constrict noticeably more than the recent average, this is a potential indication that volatility in the financial instrument is about to increase.
On the charting software below, you can see the upper and lower bands (yellow) with a 21 day moving average in between (also yellow):
Use with Other Technical Indicators
In the event a financial instrument moves outside Bollinger Bands®, traders should not jump to the conclusion this is an indication of an imminent market move. Though most market moves occur inside Bollinger Bands®, a breakout from the technical indicator is a rare occasion, but cannot be relied upon as a buy or sell signal. Additionally, while Bollinger Bands® is a widely used day trading indicator they were designed to be used in conjunction with two or more other indicators such as Relative Strength Index (RSI) and MACD.
Before acting on an indication from the use of Bollinger Bands® coupled with 2 or more indicators, backtesting historic market trends with these indicators is highly recommended. This will provide you with an idea of how effective your day trading strategy has been during similar market conditions.
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