What is Bollinger Bands Trading Strategy?

Bollinger Bands are a popular trading strategy that traders use to identify trading opportunities and manage risk. This indicator is designed to help traders understand when an asset is overbought or oversold. It works by plotting two standard deviation bands, which are made of Simple Moving Averages (SMA). This blog will help you understand all the aspects related to this strategy by covering Bollinger Band's definition, its formula, how it works, benefits, and drawbacks.

Key Takeaways

• Bollinger Bands consist of an upper and lower band plotted two standard deviations away from a simple moving average.

• Standard deviation is a statistical measure that shows how much a security's price fluctuates or deviates from its average price.

• When the market is calm and prices are not volatile, the bands tend to contract or narrow down, indicating low volatility.

• The strategy can be applied to various financial instruments, including stocks and options.

Bollinger Bands Trading Strategy: Meaning

This trading strategy uses the Bollinger Bands indicator to identify potential buy and sell signals and understand market volatility. Let's take an example to understand this concept of Bollinger Bands' trading strategy better.

Suppose you want to trade shares of a well-known Indian company called ABC. You can apply the Bollinger Bands indicator to the stock chart of the company, which will display three lines:

• A simple moving average is generally a 20-day Simple Moving Average
• Two bands plotted
• Two standard deviations which are above and below the Simple Moving Average

If the stock price moves closer to the upper Bollinger Band, it may indicate that the stock is overbought and potentially due for a correction. Similarly, if the price moves to the lower Bollinger Band, it could suggest that the stock is oversold and may need a rebound.

Additionally, you can use the Bollinger Bands to identify potential breakout opportunities. If the stock price of the ABC company breaks through the upper Bollinger Band with good volume, it could signal the start of a bullish trend. This will indicate that you should consider and take a long position. A break below the lower Bollinger Band with high volume may indicate a potential bearish trend, which would indicate that you should consider a short position.

How to Calculate Bollinger Bands?

Bollinger Bands are calculated based on a simple moving average (SMA) and the standard deviation of the price data. The following formula will help you understand the calculation better.

Middle Band = 20-day Simple Moving Average (SMA) Upper Band = 20-day SMA + (2 x 20-day Standard Deviation) Lower Band = 20-day SMA - (2 x 20-day Standard Deviation)

How to Effectively Use Bollinger Bands Trading Strategy?

There are several ways to use the Bollinger Bands Trading Strategy. They include the following:

1. Volatility Channel

Three lines make up Bollinger Bands: an upper band, a lower band, and a middle band, which is usually a simple moving average with 20 periods. A predetermined number of standard deviations are added to and subtracted from the centre band, respectively, to determine the upper and lower bands. When the bands squeeze or come closer together, it indicates low volatility in the market, suggesting that a significant price movement may occur soon. Similarly, when the bands expand or move further apart, it signifies high volatility and a breakout is less likely.

2. Trading Breakouts

A bullish breakout occurs when the price moves above the upper band. A bearish breakout occurs when the price moves below the lower band. Traders should set their stop-loss order outside the opposite band of the breakout direction.

Example: Let's consider the Nifty 50 index. If the price breaks above the upper band, a trader might enter a long (buy) position and place a stop-loss order below the lower band during the squeeze.

3. Momentum Tool

Bollinger Bands can be used to identify overbought and oversold conditions based on the concept of mean reversion. They suggest that after reaching extremes, prices will eventually move back towards the middle band, i.e., the average price.

Traders can look to buy when the price is near or touching the lower band and sell when it's near or touching the upper band. However, this strategy may not work well in strongly trending markets, where prices can stay near the bands for extended periods.

4. Trend-Following

The Bollinger Bands will slope upwards, and prices tend to reach the upper band in a strong uptrend. While the Bollinger Bands slope downwards, prices tend to hug the lower band during a downtrend.

Traders may look to enter long positions after a pullback toward the middle or lower band in an uptrend and enter short positions after a pullback toward the middle or upper band in a downtrend.

5. Combining with Other Indicators

Bollinger Bands can be used with other indicators, such as the Relative Strength Index (RSI) or the Moving Average Convergence Divergence (MACD), to confirm signals and understand the momentum.

Example: In an uptrend, a trader might look to enter a long position when the price is near the middle or lower band and the RSI shows an oversold condition, indicating the potential for a bullish reversal.

6. Double Bollinger Band Strategy

This strategy involves using two sets of Bollinger Bands:

• One with the default settings (20-period SMA and 2 standard deviations)

• Another with a tighter setting (20-period SMA and 1 standard deviation)

This creates three zones, which include:

• A buy zone i.e. above the upper tight band

• A neutral zone i.e. between the tight bands

• A sell zone i.e. below the lower tight band

Traders can look to enter long positions when the price is in the buy zone and short positions when it's in the sell zone while avoiding trades in the neutral zone.

Best Bollinger Bands Trading Strategy in Option Trading

The Bollinger Bands Trading Strategy can also be applied to options trading, particularly for volatility cases. The following are some popular strategies:

1. Long Straddle

When the Bollinger Bands contract indicates low volatility. In this situation, traders may consider a long straddle or strangle strategy. Using this approach, you purchase a call and a put option with the same expiration date and striking price. This strategy is designed to benefit from an increase in volatility, which could lead to a significant price move in either direction.

2. Short Straddle

When the Bollinger Bands expand, it indicates high volatility. In this situation, a trader may consider a short straddle or strangle strategy. In this technique, two options are sold at the same strike price and expiration: a call and a put. This strategy is designed to benefit from a decrease in volatility, as the options will lose value over time if the underlying asset remains within a specific range.

3. Volatility Skew

Traders can also use the Bollinger Bands to identify potential volatility skew opportunities. Here, the implied volatility of options at different strike prices varies significantly. Furthermore, traders can identify potential mispricing opportunities and adjust their options strategies by understanding the relationship between the Bollinger Bands and the volatility skew.

Advantages and Disadvantages of Bollinger Bands Trading Strategy

The Bollinger Bands Trading Strategy is a popular technical analysis tool that provides a visual representation of price action. Since it offers several benefits, traders should also be aware of its potential drawbacks. Therefore, understanding both the advantages and disadvantages of this strategy is crucial for making informed trading decisions. The following is the breakdown of its benefits and drawbacks.

Conclusion

The Bollinger Bands Trading Strategy offers traders a versatile tool for identifying potential trading opportunities, managing risk, and understanding market volatility. Traders may improve their decision-making process and potentially improve their trading performance by understanding the dynamics of the bands. However, it's crucial to remember that no trading strategy is foolproof, and discipline, risk management, and continuous learning are essential components of successful trading. Furthermore, it is important to use the Bollinger Bands Trading Strategy with other technical and fundamental analysis tools and a well-defined trading plan that suits your trading style and market conditions for positive results.