Technical Analysis Crash Course: Bollinger Bands

Welcome to this third edition of Technical Analysis Crash Course. Today we will have a look at the Bollinger Bands indicator.

Bollinger Bands, much like the MACD and RSI, are not a very complicated indicator to understand, but it can still be a powerful tool in your trading arsenal.

The indicator has three components to it. First, in the middle, you will see a simple moving average, or SMA for short. The SMA is nothing more than a smoothed-out average of a stock’s closing price over a specific period, chosen by you, the trader. And I say stock, but it can of course be used with other securities like forex and commodities as well.

But if you set it to 10, then it will average out the closing price over the last ten candles. If you set it to 100, it will average out the closing price over the last 100 candles, etc.

Then there are the outer bands. The outer bands are usually set two standard deviations away from the middle, SMA band. And as a stock’s volatility increases, you will notice the bands widen. Likewise, if a stock’s volatility decreases, the bands will narrow.

You can use this knowledge to trade the indicator in two different ways. The first strategy is to follow the conventional wisdom that states ‘everything always returns to the mean.’ In other words, if you see a stock break out of the bands, let’s say to the top, you can consider the stock to be overbought and you can then open a short position.

Below is such an example on Mondi (MNP):

Shoprite RSI

As you can see, MNP broke above the upper band of the Bollinger Bands and thus moved too far away from the mean. MNP then peaked and proceeded to fall. If you opened a short position on MNP when it broke out of the bands, it would have been a very good trade indeed.

But as I have mentioned before, these indicators are not always 100% correct and should be left open to interpretation.

So, another strategy is to use the Bollinger Bands as a momentum indicator. In other words, if you notice a stock breaking out of the bands, it could indicate the stock is picking up momentum in that direction.

Below is a chart of Bidvest (BVT) showing how well this strategy would have worked on two different occasions:

RSI, technical analysis chart

As you can see, on both occasions, BVT broke above the upper band. Each break proceeded to be good indicators of BVT picking up momentum to the upside. In each case, the break was the start of a new short-term uptrend.

And that ladies and gentlemen, is how you can use the Bollinger Bands to trade the markets.

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Not sure where to find trade ideas? That’s where Red Hot Trader can help you. Simply take up a 90 day trial,  set up your trading account as above and start testing these indicators on the trades!

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