What are Bollinger Bands?
One of the most well known technical indicators, Bollinger Bands are typically represented as three lines overlayed on a daily bar chart. The middle line is a moving average, most often a 20-period. Two more lines run parallel to the middle line, with the distance from the centre line varying depending on trading activity. These outer lines, or bands, are two standard deviations from the middle moving average. These bands as you may have guessed are known as ‘Bollinger Bands’. So how does this help you? The idea is that 95 percent of the price action is contained within these Bollinger Bands, and any time the price activity moves outside these bands, this is an indication of extreme activity.
Applying Bollinger Bands to your trading
Whatever you don’t bother to draw Bollinger Bands by hand or with a spreadsheet – there are so many good charting tools and software offered through CFD brokers – see this guide to the best trading software tools available.
Bollinger Bands can be interpreted as follows:
Band Width: This is the difference between a Bollinger Band upper and lower. Narrow band width is an indication of low volatility and is often followed a period of fast and substantial price movement. In short, as the bands contract, this is indicative of low volatility and as they expand to indicate high volatility.
Band Extremes: As the price reaches the upper bound, this is indicative of price strength; the lower bound of price weakness.
Crossing or Breaching the Band: When a price initially breaches the band, you would expect it to continue the trend. As the trend gets further and further past the band, the likelihood of it reversing increases.
Price Targets: In general terms, when a price movement originates at one band, the trend will continue until it reaches the opposite band. This is based on the 95 percent theory. It’s quite common that price trend reversals occur at extremes.
How Bollinger Bands can be used to decide on market Entry Points
Typically, the best Bollinger Band for entry to market is on the breach of a Moving Average (middle) line following on from a reversal at a band extreme. This can give a good indication about a short term price trend.
Bollinger Bands and Profit Targets
The theory of Bollinger Bands says that the trend will continue from one band until it reaches the other band. This can give you a price target and help you make a decision on when to exit your trade and take profits.
Bollinger Band and Stop-Loss
Bollinger Band theory suggests placing your stop loss below the moving average line.
Bollinger bands and moving averages are a great way to analyse a price trend to find a way to profit. With some practice they can be applied to CFD trading and can form a great part of your CFD trading strategy.