Have your ever seen a market bounce off a certain level a number of times and then one day break through that level completely?
Chances are, if you watch the market with any kind of regularity, the above scenario will not be unfamiliar to you.
The movement of a price higher or lower is the result of the battle between bears and bulls.
However, not all price levels are equal.
Certain levels play a key part in the war of opinion over price.
...when the market fails to break through a certain level, it creates an expectation in the minds of certain market participants.
These traders expect the same behaviour to repeat in the future and they trade accordingly.
This is why the price so often bounces off or near the same level more than once.
There's more, though.
Others may be enticed to trade if they see prices start to break through one of these levels.
In other words, when the market draws near to these levels, greater numbers may be drawn into trading.
These levels become like battlelines drawn in the sand, of interest to bears and bulls alike.
These are what we usually call levels of support and resistance.
A variety of indicators attempt to map out where these levels lie.
Bollinger bands are just one example of such an indicator.
In my experience, they are more effective than most at doing this job.
So what is a Bollinger band? And how to use it in MetaTrader?
Bollinger bands use a statistical measure known as the standard deviation to establish where a band of likely support or resistance might lie.
This is a specific utilisation of a broader concept known as a volatility channel.
A volatility channel plots lines above and below a central measure of price.
These lines, also known as envelopes or bands, widen or contract according to how volatile or or non-volatile the market is.
Bollinger bands are constructed by adding and subtracting a multiple of the standard deviation from a moving average.
What is the standard deviation?
It is a statistical measure of the dispersion of values in a data set.
The more scattered the values, the larger the standard deviation.
The more narrow the range of values in the set, the lower the standard deviation.
The lines on the chart are plotted according to the Bollinger bands formula:
There are a number of different types of Bollinger bands trading strategy.
Different strategies may utilise different approaches in how to use the bands...
...but all naturally rely on knowing how to read Bollinger bands correctly.
The most basic Bollinger bands interpretation is that the channels represent a measure of highness and lowness, for want of better terms.
Let's sum up three key points about Bollinger bands:
This is because the standard deviation increases as price ranges widen and decreases in narrow trading ranges.
Which is to say:
This means Bollinger bands analysis inherently takes into account the volatility of the market.
As we said before, there is more than one Bollinger bands trading strategy.
The versatility of the indicator allows you to tailor your trading with Bollinger bands to a variety of different trading approaches.
Best of all, the Bollinger bands indicator comes included as one of the standard tools in MetaTrader 4.
We're going to look at three different types of Bollinger band trading.
The first strategy uses the indicator as part of a breakout strategy.
This is a long-term trend-following strategy and the rules are simple:
The image above shows a daily chart of GBP/USD with Bollinger bands 2.5 standard deviations away from a 200-day moving average.
See how we get a sell signal in June 2016 followed by a prolonged downtrend?
The downtrend persists all the way through to the most recent part of the chart in October 2016.
Also notice there is an earlier sell signal in February that ended up being a false signal.
Here we see one of the reasons long-term trend-following doesn't suit everyone:
...usually such strategies yield many false signals before you get a winning trade.
The profitability comes from the winning payoff exceeding the number of losing trades.
Psychologically, this can be tough and many traders find counter-trending strategies are less trying.
Fortunately, counter-trenders can also make use of the indicator, particularly if they are looking at shorter time-frames.
You can easily adapt the time-frame if you are swing trading or day trading using Bollinger bands.
The chart below shows an hourly chart for EUR/USD with Bollinger bands and RSI.
I used the default settings in MetaTrader 4 for both indicators.
The market in the chart is for the most part in a range-bound state.
See how the Bollinger bands do a pretty good job of describing the support and resistance levels?
It's not precisely on the money, but the upper and lower bands do broadly match where the direction reverses.
Recognising that this isn't an exact science is a key to understanding Bollinger bands and their use for counter-trending.
When the market approaches one of the bands, there is a good chance we will see the direction reverse sometime soon.
A counter-trender has to be very careful about risk management, of course.
Remember, we said these levels are battlegrounds and eventually prices do breakout of such ranges.
Here's the key point:
...you need to shut down a losing position if there is any sign of a proper breakout.
In the chart above, I have added RSI as a filter to try and improve the effectiveness of the signals generated by this Bollinger band strategy.
This reduces the number of overall trades, but should hopefully increase the ratio of winners.
With this filter, you sell if the price breaks above the upper band…
...but only if the RSI is above 70, i.e. indicating an overbought market.
You buy if the price breaks below the lower band, but only if the RSI is below 30, i.e. indicating an oversold market.
It's a good idea in general to use a secondary indicator like this to confirm what your primary indicator is saying.
If you want access to an even more comprehensive choice of indicators, take a look at MetaTrader 4 Supreme Edition.
The free MT4SE plugin not only grants you an extended number of indicators but also offers an overall enhanced trading experience.
Another aspect of Bollinger bands technical analysis is the tendency of volatility to swell while following a channel of constrained volatility.
The Bollinger bandwidth gives a direct measure of volatility according to the formula:
(upper band – lower band value) / middle line value.
John Bollinger, the technical analyst who developed Bollinger bands, theorised a rule of thumb that when the bandwidth reaches a six-month low, it presages an increase in volatility.
This is known as a Bollinger band squeeze.
Bollinger's original analysis was using daily charts, but it can also be effective with shorter time-frames.
The image above shows default-value Bollinger bands plotted on a five-minute chart of EUR/USD.
Note the tight bandwidth that persists before we see the channels widen dramatically along with a breakout to the upside.
Though bear in mind that this method gives no clues about direction.
You can think of it as a warning system to alert you that the market may become lively.
Therefore, it's useful to combine it with another indicator that gives directional signals.
Using Bollinger bands in combination with another MT4 indicator will let you double-check your thinking.
An essential way of learning what combinations work for you is experimenting.
Therefore, why not practice in a risk-free environment with our demo trading account.
Bollinger bands are so versatile that they made our short list of most important indicators.
Find out what else made the list by reading our article on the most important Forex indicators all Forex traders to know.