Bollinger Bands: Basics, Distribution, Pros & Cons
Bollinger Bands is an important technical indicator in financial markets, which is used to determine entry and exit points for trades. Bollinger Bands facilitates traders to identify breakout and reversal points of market prices by incorporating concepts of mean and standard deviation, providing a robust basis for trading decisions.
This article will provide a comprehensive overview of Bollinger Bands, including its fundamental concepts, components, advantages and disadvantages, and how to plot them on platforms like MT4/MT5. Additionally, we will also discuss the important content related to Bollinger Bands, such as standard deviation and normal distribution.
What is Bollinger Bands?
Bollinger Bands is also known as Bollinger channels or Bollinger lines. It is developed by John Bollinger, a financial analyst, in the 1980s as a technical analysis tool. It is mainly used to measure market volatility and identify potential trading opportunities.
Bollinger Bands determine the range of price fluctuations by simple moving average (SMA) and standard deviation, and judge whether the market is overbought or oversold.
Components and Calculation Equation of Bollinger Bands
Bollinger Bands consist of three main bands, the middle band, upper band, and lower band. These bands dynamically reflect market changes through the combination of moving averages and price volatility.
• Middle Band: Simple moving average (SMA), typically with a 20-period setting.
• Upper Band: The middle band plus a certain multiple of standard deviations (commonly 2).
Lower Band: The middle band minus a certain multiple of standard deviations (commonly 2).
Calculation Equation for Bollinger Bands:
Commonly used default parameters are taken as an example here.
• Middle Band = 20-day simple moving average (20SMA)
• Upper Band = Middle Band + 2 × Standard Deviation (σ)
• Lower Band = Middle Band – 2 × Standard Deviation (σ)
• Band Width = (Upper Band – Lower Band) ÷ Middle Band
What Is Standard Deviation (σ)?
Standard deviation is a statistical indicator to measure the extent of dispersion of a dataset. More specifically, it reflects the deviation of the data point from the mean.
In financial markets, standard deviation is used to measure price volatility, and facilitate traders to assess the degree of price fluctuation. The larger the standard deviation, indicates the more severe the price fluctuation is, the smaller the standard deviation, indicates the more stable the market is.
According to the normal distribution theory of statistics, data would have the following characteristics in distribution:
•Within one standard deviation (α): About 68.2% (34.1% + 34.1%) of normally distributed data will fall within one standard deviation.
•Within two standard deviations (α): About 95.4% (34.1% + 34.1% + 15.59% + 13.59%) of normally distributed data will fall within two standard deviations.
•Within three standard deviations (α): About 99.8% (34.1% + 34.1% + 15.59% + 13.59% + 2.14% + 2.14%) of normally distributed data will fall within three standard deviations.
What is Normal Distribution?
Normal Distribution is the most important probability distribution in statistics. It describes patterns in vast natural and social phenomena. Its characteristics include the following.
Bell curve:
The probability density function of Normal distribution forms a symmetric Bell-Shaped Curve with a lower value at the two ends and the highest point at the mean.
Symmetry:
The data are symmetrically distributed around the center of distribution, or the mean, with lower data in the two sides, which indicates the data are evenly distributed on the two sides of the average.
Mean, Median and Mode are all equal:
In normal distribution, Mean, Median and Mode are all equal, and positioned at the center of the distribution.
68-95-99.7 Rule:
The 68-95-99.7 rule is another important characteristic of normal distribution, where:
About 68.2% of the data points locate within the range of Mean ± 1 standard deviation (σ).
About 95.4% of the data points locate within the range of Mean ± 2 standard deviation (σ).
About 99.8% of the data points locate within the range of Mean ± 3 standard deviation (σ).
Example
Assuming the results of a certain test follow the normal distribution, the mean of test scores is 70 points, and the standard deviation is 10 points. According to a normal distribution, the distribution for the points is as follows.
~68.2% of test scores will fall in 60 points to 80 points, i.e. within ±1 standard deviation from the mean.
~95.4% of test scores will fall in 50 points to 90 points, i.e. within ±2 standard deviation from the mean.
~99.8% of test scores will fall in 40 points to 100 points, i.e. within ±3 standard deviation from the mean.
Normal distribution is widely used in statistical analysis and financial markets, it is the basis of many statistical test and model, traders can improve their analysis on market price and volatility.
Advantages and Disadvantages of Bollinger Bands
As a technical analysis tool, Bollinger Bands is widely used in various financial markets, it facilitates traders to identify the status of overbought or oversold, market trends and potential reversing points. However, just like other technical indicators, there are also limitations and considerations for Bollinger Bands. The specific analysis of the advantages and disadvantages of Bollinger Bands is as follows.
Advantage 1: Dynamic Reflection of Market Fluctuation
The upper and lower bands alter according to changes in market conditions, which facilitates traders to identify the current status of the market.
Advantage 2: Applicability Across Various Markets and Timeframes
Bollinger Bands can be utilized across various financial markets, such as FX, stocks, futures, etc. No matter for short-term or long-term investment, Bollinger Bands can always provide effective technical analysis support.
Advantage 3: Identification of Overbought and Oversold
When the price reaches the upper band of Bollinger Bands, the market may be under an overbought status; when the price reaches the lower band of Bollinger Bands, the market may be under an oversold status. Traders can utilize these signals for trading decisions.
Advantage 4: Identification of Trends and Reversal Point
The expansion and contraction of Bollinger Bands can facilitate traders to identify market trends and potential reversal points. When a channel narrows, it may signal price fluctuation which is coming soon; when a channel expands, it may signal the increase of market volatility.
Disadvantage 1: False Signals During Sideways Markets
During the consolidation of the market, the price may frequently touch the upper and lower bands, which may result in misleading signals of Bollinger Bands. Therefore, traders need to utilize other technical indicators in combination to confirm the effectiveness of the signal.
Disadvantage 2: Parameter Adjustment is Required for Different Markets:
The parameters of Bollinger Bands need to be adjusted according to different market conditions to provide accurate analytical results, and this requires a certain level of experience and skill.
Disadvantage 3: Inability to Predict Market Direction
Bollinger Bands is mainly utilized to measure the volatility of the market, although it can provide information for overbought/oversold conditions, it is not able to accurately predict the direction of the market. Traders need to utilize other analytical measures in combination to establish a comprehensive strategy.
Disadvantage 4: Delayed Response to Sudden Occurrence
Bollinger Bands is calculated with historical price data, its response to sudden occurrences, such as major economic data releases or geopolitical events, may be slow. As a result, the effectiveness of Bollinger Bands may be influenced in a market with frequent sudden occurrences.
How to Plot the Bollinger Bands Indicator (MT4/MT5)
In the MT4 or MT5 trading platform, you can draw Bollinger Bands by following these steps:
How to Plot the Bollinger Bands Indicator in MT4
1.Log in to MT4.
2.Open the chart of the trading instrument.
3.Click on the menu bar "Insert" - "Indicators" - "Trend" - "Bollinger Bands"; or click on the "Indicators" tab in the navigator and select "Trend" - "Bollinger Bands."
How to Plot the Bollinger Bands Indicator in MT5
1.Log in to MT5.
2.Open the chart of the trading instrument.
3.Click on the menu bar "Insert" - "Indicators" - "Trend" - "Bollinger Bands"; or click on the "Indicators" tab in the navigator and select "Trend" - "Bollinger Bands."
Free Custom Indicators Offered by Titan FX (MT4/MT5)
Titan FX provides traders with a range of free custom indicators designed for the MT4/MT5 platforms. These tools are meticulously crafted to help traders optimize their strategies and improve decision-making accuracy. Whether you're a beginner or an experienced trader, these indicators provide strong support for your trading activities.
By simply registering for a free Titan FX trading account, you can download and install these indicators. Opening a Titan FX account is quick and straightforward, with no need to submit identity or address verification documents.
Multi-Timeframe Bollinger Bands (Titan_Multi_BollingerBands)
The Multi-Timeframe Bollinger Bands indicator not only displays Bollinger Bands within the current chart timeframe but also overlays Bollinger Bands from longer timeframes.
For instance, you can analyze a 1-hour chart while displaying Bollinger Bands for 4-hour and daily timeframes.
By observing the status of medium- and long-term Bollinger Bands, this tool helps reduce the risk of focusing too narrowly on short-term movements and losing sight of the overall trend.
Learn More and Install "Titan_Multi_BollingerBands”
Bollinger Band %B Indicator (Titan_BB%B)
The Bollinger Band %B indicator shows the position of the price within the Bollinger Bands.
Specifically, when the standard deviation parameter is set to 2, the -2σ line is represented as 0, and the +2σ line as 100, indicating the price level relative to the bands.
Learn More and Install "Titan_BB%B”
Bollinger Band Width Indicator (Titan_BB_width)
The Bollinger Band Width indicator displays changes in the width of the Bollinger Bands on a sub-chart.
While standard Bollinger Bands make it difficult to identify subtle width variations, this indicator efficiently highlights changes in the band width.
In addition to simple line displays, it can also present the width as a histogram (bar graph). When using the histogram, changes in width are color-coded based on whether the band expands or contracts compared to the previous candlestick, making it easier to identify periods of band contraction.
By focusing on the contraction and accumulation of band width, the indicator can help pinpoint potential breakout points and trend peaks.
Learn More and Install "Titan_BB_width”
Bollinger Band Trend Analysis Indicator (Titan_BB_Stop_Level)
This indicator tracks specified upper and lower Bollinger Band values, drawing lines to assess trend development.
When the trend exceeds the tracked upper Bollinger Band level, it is identified as an uptrend. Conversely, when it falls below the tracked lower band level, it is identified as a downtrend.
During an uptrend, the chart displays the tracked lower band level, while during a downtrend, it shows the tracked upper band level. This can serve as a reference for identifying trend reversals and setting stop-loss orders.
