By looking at tools on the MT4 platform and on most of the popular trading platforms, we come across a tool like the Bollinger Bands. After we superimpose it, we can very quickly see that there are only 3 lines. The creator of the index is John Bollinger, and its name is derived from his surname.
John Bollinger was born in 1950 and he is an American writer and financial analyst. The beginnings of this index date back to the eighties of the twentieth century. The Bollinger Bands index is a tool that uses a moving average and two lines above and below the average. These lines are separated by a certain size of standard deviation. Since then, not only has this tool permanently surfaced on all trading platforms but has also become a part of technical analysis.
Many modern traders can not imagine trading without using this tool in practice. This index is the result of the adaptation of the Keltner band and Donchian channel popular in the 1980s. A rumor has it that the author did not have the name for the tool he used for a long time until he was finally forced to find the name at the last moment when it gained more popularity. Without much effort, he defined the lines – the Bollinger Bands.
Construction and operation of the Bollinger Bands
The settings on the MT4 platform are – 20, 2. This should be interpreted as a 20-period average and upper- and lower band separated by two standard deviations.
Bollinger Bands, because of their construction, are often used by short-term investors. This does not mean that you can only use them at low intervals. At lower intervals, they are used in high volatility markets such as the Forex market. The price fluctuations that characterize the FX market causes that this tool has a lot of supporters. Use of the bands enables to identify the essence of the movement as well as potential turning points. The Bollinger Bands presents not only the price range but also its volatility. The volatility in this indicator depends on the range of the upper and lower bands. The larger space is between the moving average and the bands, the greater the variability.
Use of Bollinger Bands
There are several ways to use this tool. The one we are going to pursue will depend to a large extent on the current trend in the market.
Let’s start with the example of applying it in a strong trend. In the case of a strong upward trend, where we are dealing with ever higher peaks and troughs, we take long positions at the lower band. In this way, by taking positions in line with the higher tier trend, we enter into trade using the bands.
Source: MetaTrader 4
The situation is the same in the case of short positions. Then, after identifying the lower troughs and the lower peaks on the chart, we are looking for opportunities to take a short position at the upper band.
Source: MetaTrader 4
Another way to use this tool is the knockout trading when you have identified a consolidation. Consolidation is most easily seen when lines are narrowed. This is the result of the price moving in ever narrower areas. An additional confirmation is the flattening of the moving average on the chart. Then we can not see exactly at what point and in which direction the knockout will occur. An experienced trader should set stop orders above and below the consolidation area.
In the sideways trend, where it is difficult to identify the possibility of a knockout, the way to use the Bollinger Bands will be to buy at the lower band and sell at the upper band.
The most popular way to use the Bollinger Band tool, which additionally generates a buy or sell signal, is to go beyond the area of the upper/lower band. Depending on the situation on the chart, the bands expand or narrow down. Going beyond the band area is usually a reversal signal.
There comes the criticism of this tool because often going beyond the band area is accompanied by a continuation of movement. Opponents of the Bollinger Bands acknowledge that, like many other tools, it generates signals at certain moments and there is no conviction about the validity of the interpretation. Therefore, these signals should be filtered appropriately, through going to lower intervals to confirm the signal. When several intervals confirm that a position should be taken, then we can assume that the probability of the false signal is significantly lower.
Advantages of Bollinger Bands
- Ease of use
- Possibility to use at all intervals
- Easily readable signals
- Uncomplicated construction
Drawbacks of Bollinger Bands
- Several interpretations