What are Bollinger Bands
Bollinger Bands comprise of a center line, which is a simple or exponential moving average of usually 20 periods, and a higher and a lower price bands; the upper bandline is calculated by adding the value of the center line to the value of two times the standard deviation and the lower bandline is the value of the center line minus the value of two times the standard deviation. The settings of the center line and of the number of standard deviations to add to or deduct from the center line can be personalized by the trader.
The standard deviation is a measure of volatility, and for this Bollinger Bands follow the market conditions: when the price becomes more volatile, the bands get wider, and when the price gets less volatile the bands get slimmer, and this enlarging or tightening of the bands is a clear indication of the volatility of the asset price. In other words, the bands will expand as the price becomes volatile and will shrink when the price becomes less volatile.
As Bollinger himself stated in rule 21st of his set of the 22 rules as to how to use the Bollinger Bands, "Bollinger Bands can be used on bars of any length, 5 minutes, one hour, daily, weekly, etc. "
Bollinger Bands on a 5 min chart EUR/USD (20-SMA +/- 2 standard deviations)
Bollinger Bands on EUR/USD daily chart (20-SMA +/- 2 standard deviations)
Basic trading strategy with overbought and oversold areas
From a statistical point of view, if the price would move according to the normal distribution curve, the bands calculated using two standard deviations above and below the center line should contain about 96% of the price movement, meaning that only in 4% of the cases the price would continue outside the bands and that in the majority of cases if the price goes outside the bands it should return back inside the bands.
BUT, as Bollinger says in rule 14th securities prices do not follow the normal distribution curve or you should not expect them to follow the normal distribution curve, you should "make no statistical assumptions based on the use of the standard deviation calculation in the construction of the bands. The distribution of security prices is non-normal and the typical sample size in most deployments of Bollinger Bands is too small for statistical significance. (In practice we typically find 90%, not 95%, of the data inside Bollinger Bands with the default parameters)"
According to the above, when stock prices are in the upper band, you should not consider the price to be necessarily to be in an overbought area, and when it is in the lower band, you should not consider the price to be necessarily to be in oversold area. So the very basic strategy to buy when the price touches the lower band line and sell when the prices touches the higher band line does not follow Bollinger instructions and the risk in applying this simple strategy is that the price may continue upward even after the break of the upper band and may continue downward even after the break of the lower band, as Bollinger clearly states in rules n° 7 and n°8:
"7. In trending markets price can, and does, walk up the upper Bollinger Band and down the lower Bollinger Band."
"8. Closes outside the Bollinger Bands are initially continuation signals, not reversal signals. (This has been the basis for many successful volatility breakout systems.)"
Even more explicitly, this trading model has been tagged as non functional by Bollinger himself in rule 6:
"6. Tags of the bands are just that, tags not signals. A tag of the upper Bollinger Band is NOT in-and-of-itself a sell signal. A tag of the lower Bollinger Band is NOT in-and-of-itself a buy signal."
Let's see how to use the Bollinger Bonds in securities trading, combining them with another indicator to identify the entry signals in binary option trading.
A simple strategy indicated by Bollinger
A simple use of the Bollinger bands is as a trend indicator: in an uptrend, the price will move between the midpoint of the bands and the upper band, and in you would have an opportunity to buy when the price retraces back to the center line.
If the trend is down, the price will stay between the center line and the lower band.
Bollinger Bands as confirmation of setups or trading strategy
Bottomline: Bollinger Bands alone are not enough to determine entry points, as rule 22 states it:
"22. Bollinger Bands do not provide continuous advice; rather they help indentify setups where the odds may be in your favor."
Choose Speedlines trading system to pick the best entry points
Since the Bollinger Bands do not give the trader the precise entry point, you need to combine them with a trading system that tells you exactly when to enter: Buy Speedlines, The Binary Optioner's flagship trading system.